How to Address an Inheritance or Other Financial Windfall
My dad’s birthday was September 2. He died a little over four years ago just short of age 89. Thanks to his thoughtful approach to financial matters and the careful executorship of my brother, Rob, we four siblings received our inheritances in a timely manner.
What does one do with an inheritance? Both my parents and my wife’s parents have died so we have received all the inheritances we are likely to get. When we received my dad’s inheritance, we decided to give part of what we had collectively received to our children. A choice like that, though, depends on where you stand financially as well as the amount of the inheritance. And those questions do not just have to do with inheritance. They also apply to any financial windfall.
First, Some Legal Stuff About Inheritances
If you are married and you subsequently receive an inheritance or another gift from a third party, that asset is generally not considered matrimonial property. However, if you use some portion of the inheritance to purchase a family asset, such as a home, it will be included in the division of assets in the case of divorce. It may be distasteful to discuss the possibility of a breakdown in a marriage, but it is something to be aware of. If this is a concern, do not “commingle” your inheritance with other assets, and do not add your spouse as a joint owner of the account(s) where the inheritance is held.
Is It A Windfall?
An inheritance, gift, or lottery win means different things to different people. Someone who receives $200,000 but already has a paid-off house and $2 million in financial assets is unlikely to view that amount as a windfall. It’s not far off from a decent year’s return from their investment portfolio. On the other hand, someone with no savings other than the equity in a heavily mortgaged home will find $200,000 a life-changing event. Of course, for some that life-changing event may be only temporary. The classic stories have to do with lottery winners who receive millions but find themselves back in the same financial position as they were before they won.
Some Ideas About What to Do With Your Inheritance
Take a Moment to Consider Your Options
Speaking only from my personal experience, the inheritance I received did not come all at once. A part came from a life insurance payout, another part from RRIFs, for which we children were beneficiaries, and another part came from non-registered accounts, which we inherited via the will. Later, the house was sold, and we each received our portion.
That’s not always the way an inheritance goes. Sometimes it comes in a single lump sum. Regardless, there is no imperative to decide on how to use the money immediately. Jason Watt, lead instructor and curriculum writer for FP Canada’s QAFP™ and CFP® programs taught at Business Career College, suggests putting your inheritance into an investment vehicle that will lock it up for as long as 90 days.
Again, your decision depends on the windfall-like nature of the money received. If it is truly life-changing, then taking that amount of time is very reasonable. You want to make a well-considered decision. Having the money locked up also provides a degree of defence against acquaintances, “old friends,” and strangers who suddenly come out of the woodwork looking for gifts, loans, or business investment “opportunities.”
The decisions you will make depend very much on your personal circumstances. Having said that, here are a few ideas that you may wish to consider.
Pay Off Debt
Paying off debt is almost always a good idea unless the debt is deployed in a business-like manner to enable you to earn more money.
Especially High-Interest Debt
Paying off high-interest debt should be a high priority. Credit cards routinely charge 19.99% (let’s call it 20%) interest on purchases. When you consider that personal credit cards are paid from after-tax income (your take-home pay), if you are in a 25% tax bracket, that means you have to generate a return on investment of 26.67% to break even on that debt. Investing is not a realistic alternative. But paying down high debt does effectively get you that kind of return.
What About Low-Interest Debt or a Mortgage?
If you are borrowing for investment or business purposes at a reasonable rate of interest, then it may make sense to continue the loan. Interest on such a loan can be tax-deductible.
Mortgage interest on your principal residence is not, however, deductible. Nevertheless, until recently, mortgage rates have been quite low so it may make sense to continue the mortgage as is. On the other hand, if your mortgage is coming up for renewal at a much higher rate, or you have a variable rate mortgage, then the argument for paying down your mortgage makes more sense.
Other factors to consider when it comes to paying off your mortgage earlier are the penalties for the early discharge of a mortgage or prepaying the mortgage beyond the contracted maximum. Positively, however, many mortgage contracts allow the mortgagor (borrower) to make annual principal repayments of up to, for example, 15% of the original mortgage. Someone with a $200,000 original mortgage can pay up to $30,000 (15%) annually toward the mortgage. The terms may also allow you to pay as much as double your scheduled amount.
Having a lump sum of money available to take care of this debt can be a tremendous relief if you don’t like debt or are risk averse and would rather the money go toward resolving debt than investing.
Set Up an Emergency Fund
Having a reserve of money set aside for those unexpected but inevitable expenses – a major car repair, roof replacement, or getting a new major appliance – can allow you to avoid dipping into debt again and ease anxiety around making ends meet. This does not need to be a drag on the wise investment of your inheritance. It is eminently reasonable to have some portion of your financial assets in highly liquid form, that is, cash or a cash-like equivalent position that can be easily withdrawn at any time without forcing a sale at a loss if withdrawn at an inopportune moment.
A typical rule of thumb for an emergency fund is three-to-six months of living expenses. If you think you are vulnerable to a job loss or have a highly variable income, you may even want to push that rule up to a year.
Consider Short-Term Needs
Maybe your car is due to be replaced, or perhaps your family has grown, and your home can no longer reasonably accommodate another child without a renovation or moving. Either way, these can be significant five-or-six-figure expenses that may warrant setting aside some of that inheritance, depending on how pressing the need is.
Investing may be considered a “nice-to-have” rather than a necessity, but many Canadians have not saved adequately for retirement. The argument that the would-be retiree must simply keep on working is not always a possibility, though. An Angus Reid poll published in 2015 found that up to 48% of Canadians retired – or were otherwise forced out of the workforce – earlier than expected due in part to circumstances beyond their control. While situations like this can sometimes be partially addressed through benefits such as critical illness or disability insurance, investing your savings to support your needs in retirement is not something to be overlooked. Sometimes it even needs to be prioritized.
Registered Retirement Savings Plan (RRSP)
The default choice for most Canadians when it comes to investing for retirement is to use the RRSP. The combination of a tax deduction, which typically leads to a fat tax refund, and deferred tax on your investments while they are in the account, makes this a favourite of many Canadians. It also makes sense for many Canadians since we tend to have a lower taxable income in retirement than when we are in our working years. Unfortunately, a survey conducted by Ipsos Reid back in 2013 indicated that only 23 percent of Canadians were maximizing their contributions. I suspect it has not changed much in the intervening years.
I can think of at least two positive reasons not to save in an RRSP. One is that you have a good pension plan through your employer, minimizing your RRSP contribution room. A second reason is that your income is sufficiently low that the tax deduction now will be fully offset by the tax payable upon withdrawal. Even then, the tax-deferral on the income and growth inside the plan has its merits.
Having said that, if the typical pattern is likely to hold in your case (higher taxes now, lower taxes in retirement), you can use your inheritance to begin chipping away at the contribution room that may have built up over the years.
Tax-Free Savings Account (TFSA)
The TFSA only came into effect in 2009, unlike the RRSP, which dates back to 1957. Nevertheless, the TFSA is becoming increasingly popular. If you received an inheritance but otherwise do not have much in the way of income, then the TFSA is your first choice for investments. You do not get a tax deduction, but there is no requirement for earned income, nor is there an age limit for contributions, unlike the RRSP. If you have been eligible since 2009, you have $81,500 in contribution room as of 2022. You can buy the same range of investments as you can in an RRSP. Even better, there is no requirement to withdraw a certain amount, there is no tax on the income or growth within the account, and there is no tax on withdrawals. If you have a spouse or common-law partner, you can also contribute to his or her TFSA without tax attribution issues arising – just be aware of that commingling issue discussed above – protecting even more of the income generated from your inheritance from taxation.
If you have maximized contributions to your TFSA and RRSP, or it doesn’t make sense to contribute to your RRSP, then the next investment step is to open a non-registered account. Income, whether from interest, dividends, or realized capital gains is taxable in the year that it is received and cannot be avoided but depending on your time horizon and the degree of risk you are willing, able, or need to take, you can structure your investments into a relatively tax-efficient portfolio.
Gift to Children (An Early Inheritance)
If you have reviewed your finances and have a sound basis for believing you are in good financial shape for the remainder of your life, I don’t really see the point in hanging onto every penny of your inheritance until you die. Why not use some of that money to help your children out?
Such gifts can come in the form of the recently much-reported survey on down payment gifts on a new home, but it can also include money for RESPs for grandchildren, or even for experiences. A senior couple I know treated their four children, including their children’s families, to a vacation at an overseas resort. It was a great family gathering and an unforgettable experience.
This does not mean you should not be careful about giving too much too soon. Financial responsibility may be an even more valuable gift to your children than money in their pockets.
Gift to Charity
One way of teaching financial responsibility is to make gifts to charity. There are plenty of people in need in this world. As Jesus was reported to have said, “You always have the poor with you” (Matthew 26:11). I am not going to get into a theology lesson here, despite my education in the field, but there will always be others around who can benefit from the opportunity you may have to share the financial gift you have received. People often make bequests in a will. Doing so now, while alive, can be even more meaningful since you will be around to see the difference your gift can make.
This is the 163rd blog post for Russ Writes, first published on 2022-09-05.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.