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How to Handle an Inheritance

By Beth Piskora Today, about 47 million retired Americans hold roughly $10.7 trillion in retirement-account assets, according to the U.S. Census Bureau. In addition, 76 million baby boomers will retire over the next 30 years. They could eventually control as much as $136 trillion, according to a study by Boston College. Of course, these retirees will spend much of the money on their own necessities and recreation. However, the Boston College research suggests that more than $40 trillion will be passed down to younger heirs.

Too often, the recipients are unprepared. "It's impossible to give one piece of advice that would apply to every single person who receives a financial windfall," says David Braverman, vice-president for portfolio management at Standard & Poor's. "But I do think everyone could follow the same checklist to determine what to do with a windfall."

Here are some steps to consider if you receive a large inheritance or some other financial boon:

Step 1: Pay off any credit-card debt you owe. By eliminating debt that's being charged a double-digit interest rate, you're effectively paying yourself a double-digit return -- better than any other asset class these days.

Step 2: Make sure your retirement is adequately funded. If your employer offers a 401(k) plan, the extra money from your windfall can make it easier for you to make the maximum contribution the law allows.

We believe that too many people underestimate the amount of money they'll need for retirement. Americans live much longer than they did 50 years ago, and most expect to have active retirements, filled with travel and leisure pursuits. As you plan for your retirement, be sure to include estimates of expenses for leisure activities, not just basic living expenses. And don't underestimate the cost of health care, which tends to rise dramatically as you age.

Step 3: Pay down your mortgage. If your outstanding balance is more than twice your annual income, use part of your windfall to get it to that level.

Step 4: Consider your other financial goals, like saving for a child's education expenses. If you're already adequately funded for retirement, you could use part of your windfall to help out your children. "The gift-tax exclusion gives you a tax incentive to do this," says Braverman.

According to current tax laws, any individual can give up to $11,000 to any other individual -- usually a child or a grandchild, but it doesn't have to be a relative -- in each calendar year. The recipient doesn't have to claim this money as income. The donor doesn't get an immediate tax break, but the move reduces the size of his or her estate. So this is a good way to transfer wealth to heirs tax-free while you're still alive.

Step 5: Consider a gift to charity. Such donations generate a tax deduction in the year they're given. Also, you could set up a gift annuity, which gives money to charity and guarantees that you receive income for the rest of your life.

"As for the impulse to take the money and spend it on some luxury, there's nothing wrong with that," Braverman says. "But you should only consider this after going through the checklist. You don't want to be turning to your spouse in 10 years and saying, 'Gee, we sure had a lot of fun on that trip around the world. Please pass the cat food.' But if there's some small thing that could make your life easier, then by all means do it."

Our checklist assumes that the recipient will get the windfall in the form of cash, but that's not always the case. If your inheritance comes in a different form, you have quite a few things to consider. For example, a young heir may receive an investment portfolio tailored for an older person -- focused on income, perhaps, at a time when the younger person might prefer growth stocks.

Keep in mind that any sales of securities from the portfolio that you hold for some time might incur capital-gains taxes. An inherited portfolio may also lack diversification. Again, be aware of the tax consequences of any sales done to achieve a more diversified portfolio.

We at S&P think it's always a good idea to consult a financial professional to discuss the investing and tax implications of any inheritance or financial windfall. Piskora is senior editor of Standard & Poor's weekly investing newsletter, The Outlook

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