Previously, we discussed how to prepare for an upcoming inheritance in four steps:
- Know the tax rules
- Treat it like regular income
- Don’t be afraid to invest a lump sum
- Honor the benefactor
Now that you’ve received your inheritance, what should you do with it?
The answer depends on your stage in life: Millennials and Young Gen-X’ers or Baby Boomers and older Gen-X’ers.
Millennials and Young Gen-X’ers
If you fall in this camp, you are more likely to have fewer assets and higher human capital (the ability to work and earn income), families with younger kids, and debt.
So, you received an inheritance. Now what? Consider these actions steps:
Put it away in savings. Boring, yes, but a healthy savings account can liberate your finances. In my experience, people with underfunded short-term reserves have a hard time with big-picture financial moves like Roth conversions and buying proper insurance.
Pay down student loans. Knowing how much of your inheritance you should devote to paying down debt is tricky. Debt is amoral, but too much debt can hinder your ability to respond to emergency expenses, invest regularly, and be generous.
Student loans come in different forms (i.e. Federal and private) and have a confusing number of repayment plans (i.e. standard and income-driven). Having a student loan plan in place is a good first step to determining how much of your inheritance should go towards paying down this debt.
Protect your most valuable assets. People don’t love buying insurance. You don’t buy it when you’re starting your career, and by the time you think about it, it’s hard to adjust your inflated lifestyle to make room for the additional expense.
What is your most valuable asset? You! (and your income). Think about this—you are literally a money-making machine. If you aren’t insuring your ability to earn income, you’re being irresponsible and missing an opportunity to love your family well. How do you insure yourself? Through life and disability insurance.
Now that you have a nest egg, take this opportunity to review what insurances you have and what insurances you need to get. You can’t use the cost as an excuse anymore!
Prepare for the cost of education. Have you seen the cost of college lately? Now think of your kids—how much will it cost when they are in school?
I get it—college is expensive. So, you might not be able to save for the entire bill. That’s fine! Your first step is to talk with your spouse about what percentage of college costs you’d like to pay for. Let’s say you decide on a goal to pay for 50% of your kids’ college. Then, you can use a college savings calculator to estimate the future cost of education (with inflation).
Baby Boomers and Older Gen-X’ers
At this point, your assets are higher, your debt burden is smaller, and your goals are more nuanced. You also have less room for error, so use this inheritance wisely!
So, you received an inheritance. Now what? Consider these action steps:
Fill your retirement gap. First, we need to figure out how much income you need in retirement (don’t forget about inflation) along with a reasonable estimate of how much your nest egg will grow. If there’s a gap, you can prioritize filling this gap with your inheritance.
Why is it crucial to figure out retirement income now? Because this allows you to assign the specific dollar amount needed to satisfy retirement income. Naturally, any money not assigned to retirement income flows into funding other goals. The alternative is having this money inefficiently saved for “the future” without a real plan in place.
Finish off your mortgage. You’re right—we don’t usually advocate paying off your mortgage early. However, if your mortgage will not be paid off by retirement, it might be a good idea to use some of your inheritance to fast-track this expense.
Bringing a large fixed expense (like a mortgage) into retirement can be challenging. This increases your exposure to one of the biggest risks for retirees: sequence of returns risk. If you are making regular withdrawals from a portfolio, a period of poor investment returns early in retirement (a poor sequence of returns) can increase your probability of running out of money. If you have little flexibility to lower your monthly expenses, you have less options if your returns aren’t favorable early on.
Formulate your long-term care plan. The best time to think about your future long-term care expenses is in your 50’s. Why? You are healthier in your 50’s then you will be in your 60’s. This makes it easier to qualify for long-term care insurance. Secondly, starting earlier means you have more time to leverage your assets for future long-term care expenses.
How can an inheritance be used for future long-term care expenses?
A modern approach to long-term care insurance involves funding a “hybrid” life insurance policy. These can be financed through a one-time premium, a series of ongoing premiums, or both.
Fund your legacy goal. You were the beneficiary of someone else’s legacy. Do you also have a goal to pass on an inheritance? The goal to fund a legacy is really a retirement income goal in disguise. You have a nest egg that just grew. How efficiently you design your retirement income plan determines how much you will pass along to your beneficiaries.
I stated earlier that “any money not assigned to retirement income flows into funding other goals” (like legacy). If you can use less of your nest egg to get the income you need, this leaves more of your nest egg for your legacy. If you are inefficient with your nest egg—using a larger amount of your nest egg to generate the same amount of income–this leaves less money available for your legacy.
Another way to fund your legacy goal is through life insurance. Life insurance is not just for young people. You can still qualify in your 50’s and 60’s! While it can be more costly, it can be combined with your long-term care insurance to provide an efficient way to pass on (if long-term care is not needed) or preserve your wealth (if long-term care is needed).
A plan for each stage in life
Money decisions are already emotional. Inheritance adds to these emotions because of the connection to your loved one. Making the right decision is a big deal. Let us help you with a personalized financial plan that includes expert advice with actionable steps.
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