receivedinheritanceReceiving an inheritance can trigger mixed emotions. On one hand, you’ve experienced a tangible personal loss, while on the other you’ve received a monetary gain.

The difficulty lies in deciding what to do with this sudden financial windfall. While inaction is the biggest pitfall facing heirs, a Lund university study suggests that an average inheritance is gone within five years as a result of financial mismanagement.1 Instead, heirs should consider investing these assets in taxable accounts, or in property assets.

To help prepare, here are six practical steps for what to do when you’ve received an inheritance.

1. Resolve Taxes

Your first consideration should be taxes. There’s a difference between estate taxes and inheritance taxes. Federal estate taxes apply for estates that exceed a high threshold—$5.45 million per individual for 2016. A number of states also levy estate taxes; some, like New Jersey, have very low exemption levels, meaning they apply to a lot of estates. An estate is responsible for paying federal and state estate taxes before any assets are distributed to heirs.

But some states also apply inheritance taxes, which must be paid by the beneficiary—you. At present, only eight states have inheritance tax, and many beneficiaries are exempt, like children of the deceased. The best thing to do is consult a CPA or tax advisor to determine if you must pay inheritance tax.

2. Know the Pitfalls

We tend to treat windfalls differently than we treat other money, according to behavioral economist Richard Thaler. It’s just one downfall of “mental accounting,” where we don’t think of every dollar as having equal value to another.

A few pitfalls come with this line of thinking:

Failure to save. Because we think of windfalls as “found money” and tend to put it in a different mental category than regular income, we don’t always spend or save it in the same way we do with earnings.

Lottery winners are an obvious victim of this logic; one study found that winners only saved about 16% of their winnings.2

For heirs, the numbers are better, but not by much—one investigation found the average heir saved about 50% of an inheritance. Another study out of Denmark finds that the average inheritance is gone within five years, unless invested in financial assets or housing equity. An inheritance left in cash is particularly vulnerable to being spent, rather than saved.

Bad spending behaviors. What’s alarming is that an inheritance is likely to crowd out good savings behaviors, the Danish study found.

Here’s how it happens: An inheritance makes your cash balance spike. You spend a little on early splurges, and start to slack on long-term saving habits. This behavior snowballs, and a few months or years later, you face two consequences: the inheritance has been spent completely, and you’ve lost the good fiscal habits you had before.

Buying without thinking long-term. Some people fall into the trap of using an inheritance for a big purchase, but then consequently over-extend themselves. For example, let’s say you use the inheritance for a down payment on a bigger house.

Along with a bigger house comes new furniture, but also higher property taxes, home maintenance costs, homeowner’s insurance, and monthly utilities. Your monthly expenses can expand quickly while your income stays the same.

3. Consider Your Financial Goals and Invest Accordingly

Knowing that these tendencies put both your inheritance and your hard-earned savings habits at risk, the best thing to do is set goals for putting the assets to work.

Take time to look seriously at your short- and long-term goals, like paying down debts, and saving for a home or retirement.

Inertia is your enemy when it comes to managing an inheritance, and the best way around that inertia is to outline a goal-based investing strategy.

In goal-based investing, each goal will have different market risk exposures depending on the time you have set for reaching that goal.

Goal-based investing matches your time horizon to your portfolio’s asset allocation, which means you take on the appropriate amount of risk. Short-term goals are better suited to less volatile assets such as bonds, while long-term goals are better suited to riskier allocations, with  potentially greater returns.

One goal may be to shore up your emergency fund, if needed. An adequate safety net is a must-have at any stage of life.

Your windfall may also provide an opportunity to pay down debts, typically starting with any uncollateralized loans (for instance, credit cards or student loans), or loans on depreciating assets (like car loans).

You may also consider paying off a mortgage, or refinancing to a better rate that can be achieved with more equity and a lower principal loan amount. A primary mortgage is typically a last priority, since you may receive tax benefits from mortgage interest, and have a better opportunity to put that money to work harder for you in a diversified portfolio with a higher expected rate of return.

4. Assess Your Retirement Contributions

Make sure to contribute the maximum allowable amount to retirement accounts for the year. The amounts may be small compared to your overall inheritance, but retirement plans come with tax benefits that you’ll want to capture.

With an employee-sponsored plan like a 401(k), you are limited to contributing from your salary, so increase your contributions to the limit, or even up to the amount where your employer will provide a matching contribution.

You can also contribute up to $5,500 for yourself and another $5,500 for your spouse, if married, into a tax-deferred IRA account. If you’re a Betterment customer, its retirement investment strategy can help you figure out the right mix.

5. Invest for the Long Term

Knowing that an inheritance left in cash tends to disappear, make sure to follow through with the long-term portion of your plan. If your emergency fund, debts and retirement plans are on track, the rest of your savings is probably best invested in a taxable brokerage account, according to Betterment’s goal-based investment method mentioned above.

If you have a more specific goal in mind, like a home purchase in the near future, consider an investment strategy for a major purchase goal.

And if you do decide to use the inheritance for a major purchase—like a house—give careful consideration to what your normal income allows, as far as ongoing monthly expenses. The goal is to nurture your good savings habits over the long term.

6. Establish Estate Planning

Wealth needs protection. If this is your first time investing or having substantial assets, you’ll want to set up some safeguards to manage and protect your wealth.

Take time to double-check that you’ve set beneficiaries for all of your investment accounts. It’s also a good time to create a will and appoint a power of attorney, if you haven’t already. If you have children, you may also want to set up a trust for dependents. Basic estate planning isn’t always fun, but it’s a crucial step.

Putting your inheritance to work on your short- and long-term financial goals is a great way to avoid spending down an inheritance left in cash. But to truly avoid the pitfalls of inheriting, be mindful of maintaining your long-term savings habits. The best outcome is to use an inheritance to get ahead on your financial goals, while still nurturing good day-to-day spending and savings behaviors. In this case, knowing is certainly half the battle.

1The Effect of Unexpected Inheritances on Wealth Accumulation: Precautionary Savings or Liquidity Constraints?, pg. 13.
2Estimating the Effect of Unearned Income on Labor Earnings, Savings and Consumption: Evidence from a survey of Lottery Players, Pg. 16.

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