As parents die and pass their assets onto their children, I am constantly asked how proceeds should be allocated. Whereas there is no “hard and fast” rule(s) on how these monies should be positioned, there are many general guidelines, which can be used. First and foremost, please ponder the following statement…”What do you throw away, the cow or the milk?” After you answer, huh(?) when reading that statement, just think for a moment…while it may be proper to use an inheritance to pay down a mortgage, in the long run, especially if finances are in order, we believe you should consider the possibility of investing the money, giving it the potential to grow, and amortize the mortgage naturally. Whereas if you used the inheritance to pay down the mortgage, yes, you would receive a guaranteed return on your investment as the interest rate used to borrow from the bank is an obligation, which would be satisfied, it is highly unlikely that most consumers would take their mortgage payment and allocate it toward saving. Here are some guidelines to think about when allocating an inheritance. As a disclaimer, the amount of inheritance I am talking about would be of a modest nature…say $500,000 or less. Obviously, individual situations may dictate may take precedence over these guidelines we offer.
- Balance is the key. Investors “win” more often than not when (in using a baseball analogy) they hit singles rather than going for home runs. Your net worth is increased in two ways…either by increasing an asset or decreasing a liability. Think about doing both when allocating these proceeds.
- Don’t be in a rush. The money isn’t going anywhere. Speak with your advisor as to the best course of action. Be sure NOT to use emotion when making a decision. Typically, emotional or impulse decisions are not the smartest ones.
- Pay off “bad” debt. Not all debt is bad, but some is…primarily credit cards. If you have more than a “nominal” amount of credit card debt (fully realizing that nominal means different things to different people) pay it off. The next step, and this is another subject for another day, is to determine how NOT to get into credit card “hell” moving forward.
- Do NOT pay off your mortgage, but…For example, if you and your spouse are in you mid 50’s and still have 20 years left on your mortgage, you may want to take a piece of the inheritance to determine what it would take to have your ENTIRE mortgage paid for by the time you retire. Another suggestion is to take the dividends from any investments and use that as an extra principle payment. Remember, one extra payment per year on a thirty year mortgage reduces your payment period by eight years.
- Cash is STILL king. Retaining cash for opportunity costs is a worthwhile strategy… Having too much cash is like a widow saying that she received too much life insurance. Never gonna happen.
- Understanding the “step up in basis” rule. When consumers inherit money, there is, often times, confusion about the taxable nature of the asset. The “step up in basis” rule works as follows: Father dies leaving estate consisting of stocks, bonds, cash and real estate totaling $1,000,000 to his two children. Children are to share equally in the distribution. The children assume ownership of the asset retroactive to the date of death or an alternate valuation date within nine months of the decedents passing. The price they assume ownership is the value of the asset on the day they received control. If they sell the asset, there is NO federal tax due on the sale. Simple example, child inherits real estate with a fair market value of $400,000. Father paid $75,000 for the home. Child sells property for $400,000 after fathers demise…child pays no tax on the sale, as he assumed ownership at fair market value. Child has received “stepped up” value of property upon fathers passing.
- Make a plan. If you do not know how to make a plan, hire someone who does. I have had plenty of people say to me over the years, I am conservative and do not wish to take any risk. My retort is always…Are you conservative because you are…or are you conservative because you do not understand the investment business , and need someone to teach you so you comfort level will rise. It’s amazing how many people acquiesce to the latter, rather than the former.