Due to an aging population, inheritances are on the rise. According to the AARP, one-fifth of all baby boomer households have received an inheritance, and the average inheritance is $64,000. Another 15% are expected to receive an inheritance in the future, which will be a boon to their personal finance.
While inheritances are usually financial blessings, financial advisors say that many recipients don't manage them properly. A study by Ohio State University's Center for Human Resource Research found that adults who receive inheritances typically save only half of it.
Whether you're a college student getting $10,000 from a grandmother or a baby boomer getting $300,000, an inheritance should be used as a buffer to build financial security, not as a blank check for a spending spree. Experts say that if you sit on the money and make the right decisions about money management, an inheritance may offer a once-in-a-lifetime opportunity to permanently change your finances for the better.
Sit on it a while
Whether it's from lottery winnings, a settlement, or an inheritance, people who experience financial windfalls often make poor decisions when they act too quickly.
Bill Hammer, a certified financial planner and co-founder of the Hammer Wealth Group, said age isn't always a factor. He has seen 50-year-olds “make 20-year-olds' decisions” when they receive large sums of money from inheritances. Hammer said the first step to avoiding making bad knee-jerk decisions is to simply sit on the money for a few months.
“Most people will have that money spent in their mind before it even hits the account. Don't do anything with it initially. It's a psychological thing. People make better decisions when they wait a few months,” said Hammer. Other dispensers of money management advice agree.
Susan Bradley, CFP, is founder of the Sudden Money Institute and author of Sudden Money: Managing a Financial Windfall. She said because people don't have to work and sweat for inheritance money, they often view it as easy money and are more inclined to blow it.
“It's likely a once-in-a-lifetime opportunity to make your life more secure and enjoy a little more financial freedom. You have to use it wisely because once it's gone, it's gone,” she said.
Pay down debt
Mari Adam, President of Adam Financial Associates in Boca Raton, Fla., recommends that you first put the money in a safe interest-bearing FDIC-insured account until you've had time to plan how you're going to allocate and use the money. Although you'd be taking on some risk, another option would be to park it in a brokerage account and invest in some dividend-paying Blue Chip stocks.
If you're struggling with high-interest debt such as credit card debt, one of your first moves should be to allocate at least a part of your inheritance to pay it down. Carrying a $5,000 credit card balance at a 15% interest rate can cost you up to $750 per year in interest. If you inherited $20,000 and paid off that balance, you'd be saving yourself the interest every year.
“Having less debt is always better. When you pay down debt you're getting a guaranteed return on your investment,” said Hammer.
You should also consider paying down any high-interest student loan debt or a car loan, assuming the rate is above 6%.
While it might be tempting to pay off a mortgage, Hammer said it may not be the best use of the funds, especially if you're paying 4% or less on a fixed loan. That's because you may be able to earn more on your sum by investing it.
“If the spread is very close, you should just pay down the debt. But if you can make 8% on your money and your mortgage is at 4%, you might want to hold off on paying it down,” he said.
Save for your retirement or your child's education
After paying down debt, a wise use of inheritance funds would be to put it towards your own retirement or your child's education fund. Because of the long-term power of compounding, a large supplemental contribution can have a big impact later down the line. Bradley said while saving consistently over time is the key to having enough for retirement, a lump sum surge can make things so much easier.
“If you're typically putting away $100 per month towards your child's education fund and inherit $20,000 and put $10,000 towards that, you have advanced years in those savings,” she said.
Let's say you were to take $5,000 of inheritance money and put it in a Roth IRA. If that were to grow at a modest 6%, it would be worth over $16,000 in twenty years and more than $28,000 in thirty years.
Hammer said that while it's critical to save for your child's education, it should come after retirement funding. That's because while you can always use Roth IRA retirement funds to put towards education, you can't use education funds to cover yourself in retirement. If you need to pull money out of an ESA or 529 plan, you could be hit with a 10% penalty and taxes. Contributions to a Roth IRA can be withdrawn at any time for any reason without penalty.
“If you're not sure, I'd err on the side of retirement and start putting away money there,” said Hammer.
Invest it and splurge off of a portion of the earnings
There's nothing necessarily wrong with enjoying and playing with some of your inheritance money if you've taken care of high-interest debt and other financial priorities. If the amount is large enough, you could invest most of the money then use a portion of your earnings for fun.
For instance, if you were to inherit $200,000 and could earn a 5% return on it, that would generate $10,000 per year in income. It's not enough to quit your job but it could certainly provide a little extra spending money during the year.
Better yet, reinvest half of that and enjoy an extra $5,000 per year in “fun” money. That annual or monthly distribution you take would also grow as your original sum and reinvestments. In the fifth year of your investment, it would be producing more than $12,155 in annual income.
“You want to try to leave [the principal] as a cushion that you can use your entire life,” said Adam. “You can hopefully earn dividends and draw income off it indefinitely.” If you want to know how to better manage your money, investing it so that it generates perpetual returns is always a good idea.
Craig Guillot is a business and personal finance writer from New Orleans. He covers insurance, investing, real estate, retirement and debt. His work has appeared in such publications and web sites as Entrepreneur, CNNMoney.com, CNBC.com, Bankrate.com and Investor's Business Daily. He is the author of Stuff About Money: No BS Financial Advice for Regular People.
The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on your taxes, your investments, the law or any other business and professional matters that affect you and/or your business.