By: Kirk Licata, CFP®

Seven in ten people who suddenly receive a large sum of money will spend it all within just a few years.1 An inheritance, an employee bonus, lottery winnings – all are typically quickly spent. According to psychologists and behavioral finance experts, people mentally categorize a financial windfall differently than they would their hard-earned cash. So how do we ensure that we don’t fall victim to the wrong side of this statistic?

Step 1: Determine any taxes due. The 2018 federal estate tax exemption is $11.18 million for a single person and $22.36 million for a married couple, meaning that taxpayers can bequeath this amount of assets before paying any estate taxes. For example, if an unmarried taxpayer leaves you $12,000,000 in assets, $820,000 will be subject to estate tax. In the likely event that the deceased passes with assets below these levels, federal estate taxes are not a factor. A few states levy their own estate or inheritance taxes at lower exemption levels, so if you live in Iowa, Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania, you may need to be aware of any taxes owed at the state level.

Distributions from assets that are held in pre-tax retirement accounts (think IRAs and 401(k)s) are taxed as ordinary income and will likely have a defined structure for the way you must withdraw the funds. Inherited assets received outside of retirement accounts (think after-tax investment accounts, real estate, and certain small business entities) will often qualify for something called a “step-up in basis.” This means that the new basis for calculating any tax due on the sale of the asset is the fair market value on the day you inherited it, not on the day the original owner acquired it. This “step-up” typically results in little or no tax due upon sale which is an important fact to know if you are in need of immediate cash or would like to invest in a manner more suitable to your financial goals than those of the deceased.

Step 2: Think long term. It may be tempting to upgrade your house or car, but think past the moment. Will you be stuck with the increased maintenance and taxes that don’t fit comfortably in your long-term cash flow? Have you saved up an adequate emergency fund for protection during a short-term disability or job loss? Perhaps, you could pay down high-interest rate debts such as credit cards or student loans, immediately freeing up monthly cash flow.
Step 3: Establish your own estate plan. If you haven’t already done so, take the time to set up some safeguards to protect and manage your wealth by establishing a will and powers of attorney. Double-check the beneficiaries on all your accounts. Set up trusts if needed. Don’t rely on the state to decide what is best for your heirs.
Do not let a financial windfall erode your financial discipline and sensible spending habits. If you have any doubts whether you’re making the right choices, seek some guidance. We work through these decisions with our clients on a regular basis and are happy to help those trying to decide the best course of action for their financial future.

1. “Financial Psychology and Lifechanging Events: Financial Windfall,” National Endowment for Financial Education.