What to Do With an Inheritance

Anna Burton is a lead planning excellence consultant at Northwestern Mutual.

A great wealth transfer is going from baby boomers to Gen Xers and millennials. If you’re currently under 60, there is a strong chance that an inheritance will come your way soon. Sad to say, it often comes after the passing of a loved one.

According to the American Society of Pension Professionals and Actuaries, between now and 2050, Americans will transfer as much as $124 trillion in assets to heirs.

While the size of an inheritance varies from one family to another, in its most recent Survey of Consumer Finances (SCF) the Federal Reserve estimated that the average inheritance in the U.S. exceeds $110,000. That’s a significant amount for many Americans, especially when received all at once.

Should you receive such an inheritance, you might be wondering about the best way to use it. You could invest it or use it to pay down debt or as a down payment on a house. We’re here to help with tips to consider if you’ve received an inheritance.

Here’s what to do:

1. Pause before making big decisions.

After you get an inheritance, take a step back. If you’re dealing with the death of a loved one, focus on your grief first.

If you don’t give yourself time to grieve, you may make financial decisions driven by an emotional response. For perspective, many financial experts recommend waiting six months to a year before spending your inheritance. The time frame that’s right for you depends on how you process the loss. Time can help you gain perspective on how the inheritance could positively impact your financial life.

As time goes by, you may notice that your emotions about the money can be different from how you felt about the person who gave it to you. Each situation is different, but it's important to navigate the emotional aspects of the gift before deciding how and when to use the inheritance.

While you’re handling the emotional impact of a loss—plus practicalities like funerals and probate—you might consider keeping your inheritance in a high-yield savings account or a low-risk investment.

2. Understand what you’re inheriting and how it’s taxed.

Inheritances go beyond straightforward cash in a checking or savings account, so it’s important to have a clear understanding of what exactly you’re inheriting.

Perhaps you inherited assets held in a 401(k), individual retirement account (IRA), brokerage account or annuity. You could be getting physical assets, such as a home, vehicle or other property. These might be completely paid off or might have loans attached to them.

You’ll want to learn about how an inheritance is taxed at the federal and state level plus rules about withdrawals or “distributions” from certain types of accounts. For example, what you’re able to do with an inherited IRA depends on several factors, including when the account owner died, your relationship with the deceased IRA owner and other details.

If your marital status is changing, you may have even more to consider. Generally, courts treat inheritances as separate property if they are kept distinct from marital assets. One method of keeping property separate is avoiding accounts with joint ownership. For example, if you want to show that an inheritance was kept separate, avoid depositing it into a joint account used to make mortgage payments. If you’re striving to keep an inheritance separate, avoid using it to benefit both spouses. For example, don’t use it toward family travel. If you want to prove that an inheritance was kept separate, maintain clear records.

On the other hand, divorce courts are more likely to consider inheritances as marital property if they’re mixed with joint finances or if the inherited assets appreciate in value due to the efforts of either spouse.

Prenuptial and postnuptial agreements can also specify how divorce courts treat inheritances.

3. Think about your financial goals.

The best use of your inheritance might be taking steps to get you closest to reaching your personal financial goals. With that in mind, you’ll want to have a clear idea of your goals.

Ask yourself questions like these: What matters most to me in life? What have I always wished I would one day accomplish? An inheritance can be an opportunity to make those goals a reality.

These can be big, long-term goals like buying a house, starting a business, endowing a scholarship or retiring early. Or maybe you want to travel across the country with your family while they are still young—or buy your dream car.

There’s no right or wrong answer. Your goals are your goals, regardless of what anyone else thinks. Acknowledging and respecting what really matters to you is the first step toward putting your inheritance to good use.

4. Start or enlarge an emergency fund.

If you don’t yet have an emergency fund, dedicating a portion of your inheritance to starting one can be a wise decision. A well-stocked emergency fund will give you the peace of mind that comes from knowing you can weather a storm or an opportunity life throws at you. Most financial experts recommend that your emergency fund hold between three and six months’ worth of expenses, which can usually get you through common emergencies. It can help you through a short stint of unemployment or pay for large purchases like a new appliance or a vacation. If a family member needs financial assistance, your emergency fund can help you provide support without compromising your own financial stability.

But the ideal amount for your emergency fund depends on your own needs and how much risk you can accept. For some people, six to 12 months’ worth of expenses is more appropriate.

If you already have an emergency fund, that’s great! Take a look and ensure that it’s large enough.

5. Be strategic with debt.

It can be tempting to use such a windfall to pay off debts you may be carrying. If you have high-interest debt, variable-rate loans that are likely to see interest rate increases or other kinds of “bad debt,” that instinct can be a really good idea.

Paying down credit cards with high interest rates or student loans with higher interest rates is a good first step.

But be cautious about paying off all your debt indiscriminately, as there may be better ways to put your money to work. If you pay off your mortgage ahead of schedule, for example, you could end up losing tax benefits that come with your loan. Paying off low-interest debts could make you lose out on higher potential returns from investments.

Before using your inheritance to pay off all your debt, it can help to stop and make sure you’re doing it strategically. Your financial advisor can help you think through different scenarios.

6. Invest in your future.

Investing all or a portion of your inheritance can be an excellent way to turbo-charge your progress toward various financial goals like saving for retirement or setting up a college fund.

Whatever you’re investing for, a well-diversified portfolio that takes into account your risk tolerance and investing timeline is likely the way to go. Resist the urge to try to find the next hot stock. Low-cost ETFs and index funds offer a more stable path toward wealth building compared to stock picking.

If you’re nervous about investing such a large sum of money all at once, consider dollar-cost averaging. This approach invests the same amount weekly or monthly until you’re fully invested.

Work with a financial advisor so that you’re using a smart investing strategy and applying principles like optimization, diversification, flexibility, periodic rebalancing and consistency.

7. Consider your loved one’s legacy.

If you want to use a portion of your inheritance to honor your loved one, making a charitable gift can be a good way to do that.

You might make a donation in their name to a meaningful charity, cause or organization. You could also set up a donor-advised fund, start a scholarship at their alma mater or sponsor a bench at a favorite park. (Just keep an eye on the gift tax rules.)

Talk with a professional

If you’re not sure what the best use of your inheritance would be (or you have an idea but simply don’t know how to execute it), talking with your Northwestern Mutual financial advisor can help.

We start by asking deep questions to understand your goals and the assets you’ve inherited. We’ll then use that information to offer advice about how best to manage your inheritance so that it has a lasting impact.