Inheriting money is a bittersweet event. Receiving an inheritance can be a game-changer for your finances, but it also means you’ve lost someone close to you. Inheriting money comes with a responsibility to put that money to good use to improve your life.
Here are five steps to take to use inherited money to set yourself up for a lifetime of success and happiness.
Step 1: Change your relationship with money.
Step 2: Fully fund your emergency fund.
Step 3: Pay off all non-mortgage debt.
Step 4: Build up your accessible net-worth.
Step 5: Create a goals-based budget.
A massive transfer of wealth is coming
As the baby boomer generation continues to age, Millennials and Generation X will inherit over $30 trillion in assets over the next 30 years. That is an incredible transfer of wealth and has a lot of people asking the question, “what should I do with my inheritance?”
According to a survey done by HSBC in 2015, American retirees expect to leave an average of $177,000 in inheritance to their heirs.
If $177,000 is the average expected inheritance, we can classify anything above that number as a large inheritance and anything below as a small inheritance.
I recently polled my readers to ask what they would do with a small inheritance of $100,000.
34% said they would pay off their non-mortgage debt.
31% said they would invest in the stock market.
17% said they would buy a house.
7% said they would go on an epic vacation.
What would be the first thing you would use inherited money for? Let me know in the comments.
Let’s get into the five steps of how the average person could use inherited money to improve their finances and life.
Step 1: Change your relationship with money
Receiving an inheritance is a tremendous privilege and a once in a lifetime opportunity to hit the financial reset button and set you and your family up for success. Before you touch a single penny of your inheritance, it’s crucial to change how you look at money.
If the first thought the pops into your head is all the “things you can buy” with $177,000, that is a problem that you need to address.
Stop thinking of what things cost as a unit of dollars and sense.
Start thinking of what things cost as a unit of time.
If you want to buy a $2,000 flat-screen TV, don’t think of the cost of that TV as $2,000. The true cost of that TV is measured in time.
If you clear $1,500 on your bi-weekly paycheck and work 40 hours per week, that means your hourly take-home pay is $18.75.
You would need to work 107 hours to buy that TV. Does it still seem like a good deal?
Start tracking your expenses and figure out how much of your time and money you are giving up in exchange for the things you buy.
Try and focus on how much time you are giving to things you value and how much to “stuff.” The more time and money we can allocate to things we value, the happier we are likely to be.
You can also use this technique to put into perspective what an incredible gift an inheritance is.
If your hourly take-home pay is $18.75, a $177,000 would be worth 9,440 hours or about 4.75 years of your life.
Step 2: Set up a fully-funded emergency fund
The first thing to do is set aside enough cash to cover at least three to six months’ worth of living expenses.
If you spend $3,000 per month on essential spending, you should have at least $9,000 in an emergency fund.
I know that setting up an emergency fund does not sound very exciting, but it is incredibly important. Life will throw you a curveball like a job loss or a huge medical bill when you least expect it, and if you don’t have a cash emergency fund in place, you’ll have to liquidate investments or even go into debt to cover these expenses.
Take your medicine and build your emergency fund.
Step 3: Pay off all non-mortgage debt
If you have any of the following types of debt, you should pay off the complete balance, in full, right away.
Unsecured personal loans or lines of credit
Home Equity Lines of Credit (HELOC)
Step 4: Focus on building your accessible net worth
Now that you have a strong emergency fund and have cleared your non-mortgage debt, it’s time to build wealth and pursue financial freedom.
Owning a home can be a great long term financial decision. However, if your goal is to achieve financial independence, you don’t want your home to make up too high a share of your net worth.
There are two options to access the equity in your home and turn it into cash.
Sell your home.
Take out a loan against your home.
Both of these options present obvious problems. If you sell your home, you still need somewhere to live somewhere, which will add to your monthly living costs. While taking out a mortgage will provide you cash right away but add a liability in the form of deb.
That’s why I believe a better definition of wealth is not your net worth but your “accessible” net worth, which is your net worth minus the value of your home.
There are two ways to increase your accessible net worth:
Investing in assets other than your home.
Paying down debt.
Assets that can increase your accessible net worth include retirement accounts, stocks, bonds, rental properties, and ownership in businesses.
Paying down any debt will increase your accessible net worth. Since you would have taken care of all non-mortgage debt in step three, at this point, you would focus on paying down your mortgage.
I prefer to invest extra money rather than paying down a mortgage, but that will ultimately come down to your preferences and risk tolerance.
Step 5: Create a goals-based budget
I’ve long believed that the reason many people fail to stick with a budget is because they are following a budget template. The problem with budget templates is that they don’t focus on your goals; they focus on arbitrary spending rules.
That is why I came up with the idea of a goals-based budget, which takes the idea of “paying yourself first” and formalizes it into a financial gameplan.
Creating a goals-based budget is a 6-step process.
Step 1: List out your financial priorities.
Step 2: Set goals around each priority.
Step 3: Figure out how much you need to save each month to accomplish those goals.
Step 4: Figure out if you have enough money to accomplish each goal.
Step 5: Make adjustments to free up more money.
Step 6: Automate your savings.
For example, let’s say you used your inheritance to build your emergency fund, and clear all of your debt. Your primary financial goal is saving enough to have the option of retiring at a certain age.
Here is how you would build a goals-based budget to accomplish that goal.
Step 1: The financial priority is saving for retirement.
Step 2: The goal is to have enough money to retire at a certain age; let’s say age 65.
Step 3: Figure out how much you need to save each month to accomplish those goals. For example, to retire at 65, I might need to save $800 per month towards retirement.
Step 4: Maybe after looking at your monthly income and expenses, you found you were $300 short of your monthly savings goal.
Step 5: You could rework your budget to cut spending, increase your income, or pushback your retirement goal to free up more money.
Step 6: Once you confirm you have enough money in your monthly budget, guarantee your success by automating your savings.
Depending on the size of your inheritance, you might be able to knock off or get a head start on a lot of your financial goals. Once you have the basic goals like building an emergency fund, paying off debt, and saving for retirement taken care of, you can focus on other goals like paying for a child's education or taking more vacations.
An inheritance or sudden windfall of money is a chance to hit reset on your finances
Before you spend any of your inheritance, take the opportunity to think of this as hitting the reset button on your finances. That means you should start by reevaluating the way you look at money and your spending patterns. This is especially true if you are an overspender by nature.
If you don’t have a fully-funded emergency fund of a minimum of 3-6 months worth of living expenses, that should be the first thing you use your inheritance for.
Next, clear any non-mortgage debt. This allows you to wipe the slate clean and start fresh.
Once your debt is cleared, focus on increasing your accessible net worth. The simplest way to do that is to diversify your assets and make sure your home does not makeup too much of your overall net worth.
Once you have allocated all of your inheritance to emergency funds, debt, and investing, it’s time to create your post-inheritance budget. You can focus that budget on whatever your remaining financial priorities and goals are. Whether it be saving for retirement, a home, a child's education, or simply spending more on the things you value like travel, ensure those priorities are reflected in your budget.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions