Many people do not anticipate receiving an inheritance, or know what to do with it when they receive it. The amount of the inheritance may even be a surprise. If you've recently received an inheritance, it's probably not under the best circumstances. Dealing with paperwork regarding financial and legal issues are usually not a priority during an already emotional time, and it can be easy to put off making decisions.
Unfortunately, while a large lump sum may seem like a lot at the time, the money may not go as far as you think. Here are four examples of poor decisions made by those who have received a large inheritance.
1. Spending the entire inheritance immediately. This is the obvious one, but it's easy to see why it would happen. When your bank balance goes from almost nothing to suddenly having hundreds of thousands of dollars or more in it, it becomes very enticing to start looking at new homes, new cars and lavish vacations. And hey, who's to judge and say that isn't perfectly okay for you to do? You're certainly entitled to spend your money however you choose.
Just make sure you are on track to reach your basic financial goals before allocating money toward "extras." If you have verified you can sustain a large withdrawal for one of the big expenditures listed above and still be on track to reach your financial goals, go crazy! But it's important to also remember that with more expensive houses comes higher property taxes. And with more expensive cars comes more expensive car insurance, and so on. So if you have not evaluated your progress toward your basic financial needs, or if you find you are behind where you should be, it may be prudent to hold off on elevating your lifestyle so quickly.
2. Investing prematurely in a business. Once you have received your inheritance, you may also find yourself with opportunities to invest in business opportunities. These opportunities may be with a friend or family member's small business, or perhaps with a business of your own you've considered starting for years. But like any investment, it is crucially important to carefully evaluate the business and do your due diligence before making any decisions.
If your friends or acquaintances become aware of your newly acquired wealth, they may try to obtain financing or garner an investment from you at your kitchen table after a 30-minute pen and paper presentation. You need to set a standard or a policy for how you'll evaluate those "opportunities." And don't forget the age-old investment advice of never putting all of your eggs in one basket, which is something you should certainly consider when you think about how much, if any, of your inheritance you plan to invest in a start-up or small-business opportunity. As mentioned above, if you do your due diligence and the business plan looks strong, it could be a fantastic opportunity for you. But you should be slow in making these decisions.
3. Loaning people money. Unfortunately, when you acquire wealth, you become a target for some of those around you. And you may even be approached by a friend or extended family member who is in need of financial help. For some it might be easy to say no. For others you may really want to help.
But, like everything else mentioned previously, you must truly evaluate your own long-term picture first. Individuals are having to carry a heavier load than ever regarding funding their retirement. More and more workers have access only to defined-contribution plans, which they have to contribute to on their own, and Social Security continues to have an unknown future.
If you can confidently confirm, after gifting or loaning money to your friend or family member, you are still on track toward your financial and retirement goals, then there is no shame in helping someone out. If you would prefer to not provide financial assistance, it may be beneficial to create a policy for your wealth and respond with your intentions to follow your policy. For example, "I don't do personal loans." Or you could enlist the help of a trusted advisor and explain your intentions to follow the advice given to you by the advisor.
4. Leaving it in the bank. With all of the above examples of things to not do with your inheritance, how can leaving it in the bank be a bad thing? Depending on when you'll need to access the assets from the inheritance, leaving the money in the bank could be a very bad thing. Investing and wealth management is all about risk and reward.
"Receiving an inheritance might sound like a great thing, and it certainly has its benefits, but it also comes with the responsibility of making the right decisions."
When you leave your money in the bank, you generally are taking very little risk, but you are also getting very little reward. If you plan to withdraw the majority of the inheritance in a short time period, the bank is a great place for your money. Hopefully, after reading the first three points, you wouldn't plan on doing that for any reason. If you plan on using your inheritance as retirement income and retirement is 10, 20 or even 30 years away, leaving your inheritance in the bank could cost you an enormous amount in opportunity cost.
In other words, if you invest your inheritance for the long term, you will give your money a chance to grow and compound over time. Mathematically, the more time you allow the money to compound at a positive growth rate, the more significant the growth becomes. For those in your 20s, 30s, 40s and even 50s, you should evaluate your time horizon.
Receiving an inheritance might sound like a great thing, and it certainly has its benefits, but it also comes with the responsibility of making the right decisions.
(Editor's Note: This column originally appeared on Investopedia.com.)
— By Joe Allaria, CFP, partner at CarsonAllaria Wealth Management