Four Things You Must Do After Receiving an Inheritance

By Russell W. Hall, CFP®

Over the years, we have had the pleasure of working with many clients, and often that relationship has extended to their children and grandchildren. As each generation inherits, the question always comes up—“What’s the best thing I can do with this money?”

If you’re receiving an inheritance, here are four things you should do. And because sometimes what you shouldn’t do can be just as important, we’ve included four of those as well.

  1. Know What You’re Inheriting

    We start here because the type of inheritance you receive will affect your plan of action.

    First, you should know that there’s no federal inheritance tax (although a handful of states—Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania—charge an inheritance tax). The estate of the deceased person may pay an estate tax, but you as the inheritor usually won’t pay taxes at the time of inheritance.

    However, you’re responsible for any taxable event that happens afterward. For instance, did you receive after-tax assets from a trust brokerage account or bank account? Interest or dividends earned by those assets are taxable as they are paid. You’ll have to pay taxes on gains if you sell a holding and it has increased in value since you inherited it. But, withdrawals from an after-tax account are not taxable income.

    You will have a different tax responsibility for inherited IRA or other tax-deferred retirement accounts. If you inherit an IRA, distributions from that account are ordinary income, just the same as if you earned them on a paycheck. In addition, you are now subject to required minimum distribution (RMD) rules.

    Knowing the tax consequences allows you to make informed decisions. For instance, should you pay down your mortgage with your inheritance? That question might have completely different answers if you inherited a savings bank account or an IRA account.

    Don’t … withdraw all accounts and distribute everything right away. You could pay a lot more in taxes.


  2. Create an Emergency Fund

    This is the first place to start, contrary to what most people think (unless you’re one of the select few in Orange County and the broader U.S. who already have an emergency fund built up. If so, congratulations and keep up the good work!).

    For the rest of us, set aside three to six months of living expenses in savings or some other easily accessible account. If that’s a large amount, make sure you’re staying under the FDIC insurance limits ($250,000 per account holder, per bank).

    We have seen recommendations made to purchase whole-life insurance policies or certain types of annuities as a place to park emergency money, with the idea that you can tap the cash value of those policies if needed. We don’t think it makes sense to tie up the money this way, especially in products that often have high fees, and we would avoid these products. Keep your emergency fund separate from your investments, and don’t stress too much on the rate of return that you’re earning at the bank—that’s not the purpose of that money.

    Don’t … leave all your inheritance in the bank if you plan to use some of it for your retirement. Over time you’ll lose out to inflation. 

  3. Pay Off Debt

    Do you have credit cards or other revolving debt that are charging high rates of interest? Perhaps leftover student loans? Look to pay those down after your emergency fund is in place, but be careful when taking money out of tax-deferred retirement accounts to do so. In California, you could easily pay a combined federal and state tax rate of 30% on distributions, and the extra income could also increase the taxability of other items (like Social Security).

    Another potential issue around paying off credit cards all at once with an inheritance is that all too often, the cards are not closed and are just left available. There’s a wonderful sense of freedom that comes with paying off debt, but sometimes that can lead people to feel they can go back and start charging all over again. Be aware of this if that’s your situation, and if you can cut up the credit cards, you will probably be better off in the long run.

    We briefly touched on this earlier, but a home mortgage should generally be the last debt you pay off. That’s due to a combination of low mortgage rates and favorable tax treatment for mortgage interest, even if the tax savings aren’t as attractive anymore due to tax law changes. As with credit cards, you could wind up with a big income tax bill if you distribute inherited retirement accounts to pay off a mortgage.

    We like our clients to be debt-free, so we’re in favor of paying down mortgages. However, we wouldn’t put that goal ahead of saving for retirement. It is possible to be “house rich and cash poor” in retirement, and it’s tougher to get cash from home equity than to take withdrawals from retirement savings.

    Don’t … pay down all your debt at the expense of your retirement plan. 

  4. Plan for Your Future

    What a surprise—a financial planner telling you that you need a financial plan!

    Self-serving advice aside, we could tell you story after story of large inheritances that were spent in a very short period, bad investments or loans made with little or no research, and other disaster stories.

    Knowing your financial goals and developing a comprehensive strategy for saving, investing, and spending is not nearly as fun as the latest hot stock tip or buying that car you’ve always wanted. But over your lifetime, having a plan in place for your inheritance money and your other assets can help guide you to a successful retirement. A good financial advisor will put your interests ahead of their own (a true fiduciary), and they will have the goal of helping you do the best you can with your inheritance.

    Don’t … assume that all financial advisors or wealth managers are the same. Avoid the many people trying to sell you products, and instead look for a fee-only advisor. 

We hope these tips are helpful. If you have additional questions, schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.

Russell W. Hall, CFP®