As the saying goes, there are two certainties in life; death and taxes. Unfortunately, when death comes knocking, often taxes do as well. However, once taxes are paid and the estate is dealt with, there is generally one or more people left with an inheritance.

Oftentimes, inheritances are used frivolously. People use them to go on vacation, buy themselves new toys, upgrade their car, etc., even when other parts of their financial lives are not in the greatest spot. Not that those things are necessarily bad, but oftentimes they aren’t the prudent decision.

So if you have found yourself as the recipient of an inheritance, big or small, what is the best course of action? What should you do with that money and where should you put it? Below is some important information for both the recipient and the giver of inheritances.

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Keep it Separate

First off, and one thing many people are unaware of, is that inheritances are not considered common marital property. This means that if you receive an inheritance, keep it separate from other marital assets. If a breakdown in the relationship happens, the inheritance would not be subject to the calculation regarding the division of assets.

Keeping it separate doesn’t mean that you have to keep it a secret. But you should consider holding/investing the money in a separate account. However, this can be a tricky situation. To the non-recipient spouse, it may seem that the inheriting spouse, is planning for a relationship breakdown, which may not be the case.

Every situation and relationship is different. Good communication, trust, and openness are always the key. However, with the extremely high rate of divorce, it is important to also look after your personal financial well-being. If keeping it separate is going to cause relationship issues, it may not be worth trying to keep it separate. Like I said, tricky situation.

Pay Down Debt

A great option for many people is to put a chunk of the inheritance towards personal debt. People today are saddled with extremely high amounts of debt, and with interest rates supposedly set to continue rising, the carrying costs of that debt will continue to rise.

Paying down debt, especially debt with high-interest rates (CC, LOC, etc.), is almost never a bad option. It decreases monthly carrying costs, and you can think of the interest saved as the rate of return. So if you have a credit card with 22% interest and you pay it off, you just locked in a 22% rate of return.

One thing to note is that using inheritance to pay down debt could go against the first point of keeping inheritances separate. For instance, if the inheritance is used to pay off the mortgage, it would be used to pay of the house which is considered common marital property. In this case the inheritance used to pay down the mortgage would be considered as common marital property and be subject to division.

Create an Emergency Fund

With a large swath of the population saddled with significant amounts of debt, many are also on the brink of solvency or dipping into cash reserves. Having an emergency fund is crucial for everyone regardless of where you are in life. Emergency funds are something we have talked about frequently and in today’s economic environment having access to quick cash is very important.

The size of your emergency fund will vary. It should be a minimum of three month’s living expenses. However, if you find yourself in more tumultuous financial circumstances, you should consider having six month’s living expenses available.

Invest

Investing the inheritance is another great option. If the inheritance is received at a young age, this can set up great for the future. However, the question when you receive a large sum of money becomes, where do you invest it, and do you invest it all at once?

Below we look at multiple different accounts that you should look at utilizing with the inheritance proceeds. When it comes to investing all at once, we believe that the best strategy is a wade-in/dollar-cost averaging strategy. Especially when the person who received the inheritance has no investment experience.

A wade-in strategy may look something like the following. You received $250,000 and decide to invest 13,500 every month for the next 18 months until the whole amount is invested. This ensures that if there is a market downturn the whole amount is not subject to investment risk.

Click here to read more about wade-in/dollar-cost averaging.

TFSAs

When an inheritance is received, our recommendation is that you should first look at fully utilizing your TFSA contribution room. TFSAs are our preferred investment vehicle of choice in most situations. They offer a lot of flexibility with withdrawals and deposits and everything is completely tax-free.

To learn more about tax-free savings accounts check out, You Should be Maxing Out Your TFSA.

RRSPs

RRSPs are a great savings vehicle where any contributions are a direct deduction against your income. We generally recommend that RRSP room be saved for years where income spikes above the $100,000 level or for when you are in your peak earning years. Using an inheritance to contribute to an RRSP is not a bad option. Making a large contribution could even reduce your income to $0 hypothetically. However, you may not want to fully utilize your RRSP entitlement in one year and rather spread it over multiple years.

Before making large contributions to your RRSP you should consult with your tax and financial professional.

Non-Registered Investments

Non-registered investments are your general investment accounts. You do not receive any tax deferral and tax advantages using a non-reg account. The tax implication is dependent on the underlying investments held in the account. The gains could be taxed as interest, dividends, or capital gains. In most circumstances, it is best to fully utilize your TFSA and RRSP room prior to investing in a non-registered investment account.

RDSPs

Monetary inheritances can come from many sources. One such source is RRSPs/RRIFs. Rather than having RRSPs/RRIFs flow through the estate, which would be a taxable disposition, if there is a disabled beneficiary, part or all of those proceeds can flow into a RDSP tax deferred.

There are limitations on how much can flow from RRSPs/RRIFs to RDSPs. In order for this transfer to tax place without tax implications, the disabled beneficiary would have to be directly named as the beneficiary on the RRSP/RRIF account.

For more information on RDSPs and using the rollover check out, Using an RDSP: Case Study.

Conclusion

When you find yourself as the recipient of an inheritance be prudent in the decisions you make with it. Sit down with a financial planner and design a plan on the best course of action. Should you invest it, pay down debt, or use it to cover expenses you have been putting off? Should you keep it separate? These are all questions your advisor should be able to give objective answers to.