Managing an inheritance? Experts offer advice on handling any windfall.

Most people don't experience the thrill of a truly life-changing financial windfall like the one portrayed in stories.

Inheritances are a common occurrence, with some individuals inheriting valuable items such as wine collections or furs, along with the accompanying funds. However, the average American inheritance across all age groups and income levels between 2001 and 2019 was only $12,000, according to a study by the University of Pennsylvania using data from the Federal Reserve's Survey of Consumer Finances.

The average inheritance amount for Americans who received one was about $184,000, which is a healthy sum but not enough to retire. However, the vast majority of Americans did not receive any inheritance at all, which dragged down that number.

If you receive an inheritance, you'll need to incorporate it into your financial plan, which may require a significant amount of effort depending on the form of the inheritance.

Inheritances come in three primary forms: cash, real estate and investments.

According to Clay Ernst, executive director of financial planning at Edelman Financial Engines, the ideal inheritance in the United States would be in cash, but typically, it's a blend of the three.

Here's how financial pros say to handle all three.

How to handle a cash inheritance

Inheriting cash up to $12.92 million in 2023 won't require you to pay federal taxes.

"According to Pratik Patel, managing director and head of family wealth strategies with BMO Family Office, receiving cash inheritance is the simplest form of inheritance. There are no concerns about tax implications or basis when selling. The money is yours to use as you please."

If your financial plan is secure and this money is extra, you can indulge in a luxurious vacation or treat yourself. However, for those of us living in the real world, there may be some effort required.

Perhaps now is the time to establish an emergency fund if you don't currently have one.

Patel advises paying off high-interest rate debt immediately, as these rates are typically higher than the returns you'll get in the stock market.

If you have expensive debt paid off, you may want to consider investing the money in a low-risk option like an S&P 500 index fund, says Patel.

How to handle inheriting real estate

If your parents did not reside in a palace, you are unlikely to exceed the inheritance tax limit on real estate. Additionally, due to the step-up in basis rule, you will not owe any tax on inherited property initially.

When the owners of a house die, the value of the inherited home resets, and if Mom and Dad had paid $100,000 for the house and sold it for $500,000 while they were alive, they would owe tax on the $400,000 gain.

When the house is inherited and you take possession, the value of the house for you (also known as your basis) is the fair market value of the house, which is $500,000. If you sell it for that amount, you won't realize a gain from the IRS's perspective.

"While the clock ticks, Ernst notes that there is a step-up in basis at the time of death. However, the estate settlement process can take six to twelve months, and real estate values and the market can fluctuate."

If you have siblings, some may want to sell the house for cash, some may want to rent it out, and some may want to move in.

It is wise to get a property appraised immediately, advises Ernst. He recommends using at least two appraisers to ensure accuracy. According to him, "one appraiser will always be higher or lower than the other. If you use two, you can take the average. If you use three, you can take the middle one."

If one sibling wants to buy the others' share of the home, obtaining appraisals will simplify life for everyone and provide a benchmark for deciding when and how to sell the home.

Patel advises that while waiting for a hotter housing market to make a sale, it's important to consider the upkeep costs that often come with real estate.

""Be aware of the expense in real estate before making a decision, as it can negatively affect your cashflow if you don't liquidate and sell," he advises."

How to manage inheriting investments

Inheriting investments in a taxable account means you receive a step-up in basis, allowing you to sell them at their current market value. This is like real estate, where you can sell a property at its current value, regardless of the original purchase price.

If you don't sell your investments immediately, you'll still be subject to tax on any gains you realize, as if you had purchased the stock at its market value.

It is important to monitor retirement plans funded with pre-tax dollars, such as 401(k)s and traditional IRAs, when dealing with different types of retirement accounts.

"Patel says, "When I withdraw that money, it adds to my income, which may be subject to the highest tax rates during my peak earning years.""

The IRS allows you to withdraw money from traditional accounts within a 10-year timeframe, providing flexibility for tax planning. However, Roth accounts follow a different set of rules and conventions.

To ensure tax efficiency when inheriting money, it is wise to consult advisors, advises Ernst.

"It is recommended to involve professionals such as a tax advisor and an estate planning attorney during the process, particularly for more intricate estates."

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