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Q&A: "I am Going to be Receiving a $200,000 Inheritance. Where do I put this Money?"

Insurance Investment Retirement Accounts Tax

Question and background: 

I am a 40 year old single female. I am going to be receiving a $200,000 inheritance. Where do I put this money? Annuity? Roth? Invest? I make $40,000 annually. I have $40,000 in 401k. I have $60,000 left on mortgage for condo that is underwater but no other debt. I have $20,000 liquid. I want to make the best decision for future financial security.

Larry's answer: 

This inheritance will certainly strengthen your financial position. I agree with my colleagues that you could benefit from hiring a financial advisor to help you put together a financial road map (and possibly manage some of the funds for you). But generally speaking, here's how I might approach things if I were in your shoes.

Mortgage Pay-Off 

I'd start by paying off your $60,000 mortgage. Why? Five reasons:

1) If your mortgage rate is 6%, for example, paying it off now is kind of like earning a "guaranteed return" of 6% right off the bat. 

2) Financial assets (stocks, bonds, etc) are very overpriced right now, mostly due to monetary policy on steroids thanks to the Federal Reserve and global central banks. Historically, when the long-term valuation measures of US stocks have been as overpriced as they are today, the next 7 to 10 years has usually resulted in very poor returns (1% to 3%, for example). Can markets still rise? Sure. But imbalances like these tend to get corrected. So fully investing your $200,000 now may well be one of the worst times to enter the market ("buying high").

3) You're in the 15% federal income tax bracket (plus state, if it levies an income tax). If you itemize your tax deductions, the loss of deductible mortgage interest by paying off your mortgage is not going to be a big issue at the 15% tax bracket. 

4) There is an unquantifiable peace of mind that comes from having all debts paid off.

5) Having paid off your last remaining debt, you can then take the funds you would've paid on the mortgage and apply them monthly to increased savings...and/or increased investment when financial markets can be bought at better prices.

Roth IRA or Roth 401(k) 

Does your current 401(k) plan have a Roth 401(k) option? If so, I'd redirect contributions into the Roth 401(k) option and increase them to max-out at $17,500 per year. If your employer doesn't currently offer a Roth option in the 401(k) plan, ask Human Resources to add it. 

Now, if you're making $40,000 per year, then maxing-out your Roth 401(k) at $17,500 will reduce your take-home pay. But you will no longer have your mortgage payment (per above) and if you still need more than your take-home pay for living expenses, then you can tap a little of your inherited funds to cover it.

The idea behind this strategy is to (substitutionarily) turn inherited already-taxed funds into tax-free Roth funds that have opportunity for tax-free growth between now and when you retire...and into retirement. 

If you have no Roth 401(k) and your employer won't add it, then you can set-up a Roth IRA and contribute up to $5,500 per year (2014 limit).

Disability income insurance 

Even though you'll own your condo outright, have retirement savings, and funds from the inheritance, your primary asset is still your ability to earn income for the remainder of your working years. 

If you don't already have a basic level of group disability coverage through work or if it's inadequate, you should consider buying an individual disability insurance policy. This is, perhaps, even more important for you as a single person.

Remaining inheritance funds 

Per my view about overpriced financial markets, I'd be very reluctant to invest the remaining inheritance right away. But since none of us has the proverbial "crystal ball," you might decide to open a brokerage account and invest 30%-50% of it, for example, in a diversified portfolio of low-expense funds. Then keep the rest in a money market fund (in the brokerage account) until financial markets experience some pullback and you can buy-in at better prices. 

Alternatively, you may wish to hire an advisor to handle portfolio management for you. But if you agree with my view about overpriced markets, be sure you find an advisor who'll follow that approach. You'll be looking for an advisor who employs tactical asset allocation...and we're in the minority. Most advisors set you up in a model portfolio that gets periodically rebalanced but completely ignores the overvaluation or undervaluation of different classes of investments.

This answer is a lot longer than I'd intended, but hopefully it gives you some useful ideas and next steps to consider. Feel free to get in touch if you have questions or I can be of any help.