Aug 20, 2024
An inheritance windfall can provide many people the opportunity to turn their lives around, from paying off lingering debts to putting a downpayment on a home.
Say, for example, you’re 45 years old and received a $100,000 inheritance. The possibilities may seem endless: you can invest, save, or even splurge on a dream vacation.
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The big question, though, is which approach do you take? Should you be responsible with each and every dollar? Or should you use the money for a big-ticket purchase you couldn't otherwise afford?
There are a few things to consider first before reaching a decision.
How much is an inheritance taxed?
The first step in deciding what to do with an inheritance is to understand exactly how much you'll have left over after sorting out any possible taxes.
The good news is, you may not have to give the taxman as much as you initially thought — but it all depends on where the decedent lived and/or owned assets.
An inheritance tax is fairly uncommon and is essentially a levy on assets inherited from a deceased person. As of 2024, there are only six states that have an inheritance tax. Unlike an estate tax, inheritance taxes are paid by the beneficiary.
The six states with an inheritance tax are:
- Kentucky
- Maryland
- Nebraska
- New Jersey
- Pennsylvania
- Iowa (although they are in the process of phasing it out)
When determining the tax rate, it can vary depending on the decedent’s home state and considers both the amount of the inheritance windfall and your relationship to the deceased.
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Inheritance taxes are only assessed by the state (if applicable) where the decedent lived or owned property. If you, as the beneficiary, also live in a state with an inheritance tax, those rules don’t apply in this situation.
If you happen to inherit property and decide to sell it at a profit, you may have to pay capital gains tax.
These are calculated using a stepped-up cost basis. This means the assets are adjusted from the original cost basis to the market value at the time of the decedent's date of death.
Should the beneficiary decide to sell the asset at a later date, this new higher cost basis is subtracted from the sale price to determine the capital gains tax liability.
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Consider the current state of your finances
Once you’ve dealt with any taxes, you'll have to decide what to do with the rest of your windfall. Your current financial situation should influence your choice.
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If you're already in the midst of building a nest egg for retirement, have a manageable mortgage, and no credit card or high-interest consumer debt, then you don't necessarily need to use every single dollar of the inheritance to do the "responsible" thing.
On the other hand, if you have significant credit card debt, nothing saved for retirement, or don’t have enough money for a downpayment, using the inheritance to dig out of a financial hole may be your best option.
What can the money do for you?
Once you have a clear idea of how much money you've inherited after taxes and whether you're in need of a financial lifeline, it's time to look at what the money could do for you.
The reality is that $100,000 is enough to change the trajectory of your life — if you play your cards right.
The median 401(k) account balance among those between the ages of 45 to 54 is only $60,763, according to Vanguard's 2024 How America Saves report.
Since some experts recommend having saved around three times your salary by age 40 and six times by age 50, many Americans are far behind where they should be.
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Let’s say you have nothing saved. Investing your $100,000 inheritance into a retirement fund at age 45 would leave you with a whopping $672,750 over 20 years, assuming a 10% average annual rate of return.
That can make a huge difference in your overall retirement security — and enable you to hopefully take a couple dream vacations in your golden years.
That being said, there's never any guarantee you'll have a healthy tomorrow. There's something to be said for enjoying some of the money ASAP as long as you aren't in a deep financial hole.
Let's say you spend $10,000 of that $100,000 on an amazing vacation and invest the remaining $90,000. You'd still find yourself with $605,475 in 20 years. That's $67,274 less than you would have had if you invested your entire inheritance, but it's still a good chunk of change.
If you’re still not quite sure what to do, consider enlisting a financial adviser to help you plot out your next steps.
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Christy Bieber has 15 years of experience as a personal finance and legal writer. She has written for many publications including Forbes, Kilplinger, CNN, WSJ, Credit Karma, Insurify and more.
