What should I do with an inheritance?

If you’re expecting a large windfall, you might be tempted to ask a friend what to do with it. They’ll almost certainly respond “Give it to me … ha ha!” – the laughter belying their seriousness. Most of us are used to living from month to month and have no experience of handling a significant lump sum. Unfortunately, though, it’s not a situation that elicits much sympathy. “A nice problem to have,” is one of the more benign responses you can expect.

Sudden wealth can be stressful.  A common reaction is to solve the problem by spending it as quickly as possible. The money is gone and we’re returned to the familiar situation of just getting by. An article in The Conversation suggested the average person who receives an inheritance quickly loses half of it through poor decisions. While you’ll certainly want to enjoy yourself with some of the money, don’t neglect the opportunity to make it serve you in the longer term.

In this post, I’ll help you think through the options for making the most of an inheritance, and also point out a few potential pitfalls.

Before you start …

Have you actually received the money? Most estates in the UK go through a system called probate. The Government tots up the deceased’s assets and liabilities, then deducts Inheritance Tax (IHT) from anything left over. Currently, IHT is levied at 40% on estates valued over £325,000. There are exemptions on main residential properties and for spouses, so please read my Inheritance Tax post for more details.

Uncle Norman might’ve left you £100,000, but this could drop to £60,000, depending on how he organised his finances. And if he also gave you money within the last seven years of his life, you could be liable for additional IHT tax, too.

So, don’t resign from your job until you know exactly how much you’ll receive.

Now let’s look at five ways to spend your inheritance.

1. Pump up your pension

Before you help anyone else, make sure you’ve provided for your own future. Check how much money you’ve got in your pension pot and what you can expect to receive from the state pension. Adding a lump sum or increasing your monthly contribution now could ensure a comfortable retirement.

You can only pay a maximum of £40,000 or the equivalent of your salary (whichever is lower) into a pension each year. You should take into account any existing contributions when calculating how much you can invest. For example, if you earn £35,000pa and a total of 10% is contributed through a workplace pension, you could put another £31,500 into a pension scheme.1

There’s also a lifetime limit on how much you can invest in your pension. For the 2019/20 tax year, this is £1,055,000. That might sound a lot, but it’s easy to exceed if you’re a high earner with a generous employer.

2. Give it away

Perhaps you have enough money already and do want to help that importunate friend. Or you’d like to give your children a financial buffer. Again, you need to consider inheritance tax. There are limits on how much you can give away each year without creating potential tax liabilities for your beneficiaries. If you have a large sum to distribute, it’s worth consulting a tax accountant to get expert advice. Also consider whether your beneficiaries know what to do with a lump sum. Will they just blow it? Might a monthly allowance be better?

There’s no IHT payable on charitable donations, so they’ll get the maximum benefit from any largesse.

3. Invest in an ISA

Often, people aren’t sure what to do with an inheritance and just stick it in a cash savings account. Although this is better than keeping it under the mattress, it isn’t a good long-term solution. Not only will your money shrink with inflation, but you might also have to pay tax on the tiny amount of interest earned.

If your lump sum is more than £40,000, you should consider an ISA. You can save up to £20,000 in an ISA each year without paying any tax and there’s no overall limit on how much you can accumulate. There are currently six types of ISA:

Cash is generally a good option if you need to access the money within the next five years. In this situation, you’re prioritising security over growth. Anyone wanting a decent long-term return on their investment should investigate a stocks and shares ISA. This is riskier – your money is exposed to the vagaries of the stock market – but it offers some protection from inflation.

4. Buy a bigger house and live in the suburbs

For most of us, the overwhelming temptation is to buy a bigger or swankier house. Remember, though, that a bigger house could mean higher running costs. Have you saved enough in your ISA to cover those future commitments? And moving to a leafy location might involve a longer commute and associated costs. Is there enough cash to cover all the implications of a larger property?

5. Pay off your mortgage

While a Georgian rectory could be fun, a mortgage-free life might be even better. Paying off your existing debts (and not acquiring any more) gives you additional options. Perhaps you could retire early, reduce your hours at work, or retrain to do something more fulfilling. Mortgages are often described as ‘good debt’, but they’re still debt. Reducing your burden gives you freedom.

Check your mortgage agreement carefully. Depending on your terms, some lenders only allow you to overpay by a maximum of 10% each year. Work out the impact of any penalties and see whether it’s worth drip-feeding the money instead of making a lump sum payment.

Conclusion

Of course, what you do depends on the size of your inheritance and your personal circumstances. Allow yourself time to ponder what’s right for you. Just because this was an unexpected windfall, doesn’t mean you should just spend, spend, spend. It’s unlikely you’ll get impartial advice from friends (and definitely not from family), so look for neutral sources of support. The right decision could mean a secure financial future in which that inheritance works hard for you.

This post is for information only and does not constitute financial advice.

Image © fotofabrika – stock.adobe.com

  1. Including the tax relief you receive. []
Catherine Pope

I'm a financial coach who loves Victorian novels, technology, and big books about pensions.

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