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How to use an inheritance: Pay off debt or invest?

Question: Any ideas on how we should use an inheritance? My husband and I recently inherited $50,000 and we can’t seem to agree on whether we should invest all of it or pay off debt of about $18,000 and invest the rest.  

Answer: On the surface, it seems the answer to your question should be straight forward, so here is my short answer:

In general, if your costs to borrow money are higher than what you can safely earn on the same amount, the debt should be paid off first.  How much can you safely earn? Well, as of this writing bank interest rates are yielding very low returns and while investing may generate a higher rate of return your investment could also go down in value. From the way you pose this question, it seems logical that you should probably attack the debt first, build an emergency reserve and start to educate yourself on investing before you jump into it head first. But …

Here is my longer answer:

I’m reading between the lines of your question and think there is probably a lot more to your story than what you are sharing.   Since I don’t have all of your details, let me highlight the basic factors you should consider before making your own decision:

What are the tax consequences if you draw down on this inheritance, either incrementally or all at one time?

Have you received the inheritance all in cash or is it already invested such as in stocks, bonds or mutual funds? Is it in a regular taxable account or is it within a retirement account?  Before making any final decision understand how you will be taxed if you draw down on the funds.  If it’s in a regular investment account or cash, it may have minimal or no tax implications — but that will depend on how the assets passed to you from the decedent.  If the $50,000 is in a retirement plan (Roth, IRA, 401k, etc.) it may not make sense to draw down more than the minimum required in order to preserve and extend the tax benefit of those accounts.

What are the details to your debt?  

On that $18,000, how much are you paying in interest? What is the term, or when will it be paid off if you continue to carry the debt as is? Is it at a fixed or variable rate? Here is a link to debt repayment and other financial calculators where you can crunch the numbers.  What type of debt is it and can you write it off on your taxes?  FYI, just because some interest is tax deductible does not mean the debt is worth holding because you do not get a 1:1 benefit. This is just something to consider as the tax savings reduces the borrowing cost  — but there is still a cost. If the cost of borrowing is above what you can earn in a money market, then it probably makes sense to pay down the debt provided that accessing the funds will not trigger more in taxes than the interest saved.  This requires some number crunching. For example, if there is a tax impact on drawing down on the account, check to see if it makes sense to split the draw down on the account over more than one year to soften the tax burden.

Do you have a cash cushion?

If you are considering using this windfall to wipe out debt, it sounds like you may not have an emergency reserve or cash cushion.  If not, why not? Are you living beyond your means or was there an emergency that had you turn to debt? Are you taking steps to spend with awareness (you understand your needs vs wants) and are you putting money away before you have it available to spend? Before deciding between investing and paying off debt, step back and make sure you have enough of a good-old-boring cash cushion so you can avoid new debt in the future.

How much do you anticipate to gain if you invest the inheritance and how do you plan to invest it?

You didn’t say how you planned to invest and that leaves open a wide, wide range of possible scenarios.  Not all investments are created equal. If you were to invest, make sure you have realistic expectations on the growth (upside potential) of the funds as well as the downside risk. As of the time of writing this post in June 2014, we have experienced an extended period of positive stock market performance. Consider how this recent performance might be influencing your perspective on investing.  In evaluating investment decisions, make sure you understand how to diversify your investments, understand how liquid the investments are (can you get to them easily) as well as the costs associated with the investments and who is recommending the investments including the benefit they receive if you follow their recommendations.

Have the two of you discussed how you feel about the inheritance as well as how to use an inheritance? 

So far, we have considered the practical elements of the inheritance but we haven’t looked at the equally important emotional aspect of the inheritance.  Obviously, I don’t know the details, but I would like both of you to consider that you probably have feelings about this inheritance, how it came to you and the person who died. Those feelings might be different for each of you and you may not even be fully aware of your own feelings.  Common emotions that can cloud our judgement are guilt, anger, sadness, and fear. With a couple, each of you may be experiencing different emotions, unaware that you are not on the same page as your partner. It’s time to talk about it and to discuss how your emotions might be influencing your perspective, how the financial choices you are considering are triggering your emotions and how your emotions are impacting your actions and each other.

I’d like to hear from you on how you handled an inheritance.  What issues caused problems for you, practically or emotionally?  Let me know in the comments.

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