Investing an Inheritance
It’s a gift that can suddenly bring you a lot closer to your goals – so plan wisely.
Baby boomers are expected to inherit an estimated $750 billion in the decade ahead, just part of the greatest intergenerational wealth transfer in Canadian history.1 Thanks to our lofty real estate values, the amounts passed down here in Metro Vancouver can be substantial.
If you’re set to receive an inheritance, it’s often a time for mixed emotions. There’s dealing with the grief of losing someone close. Add to that the potential for family conflict over the estate, or fear you won’t make the right decisions with the legacy your loved one worked hard for. That’s why it’s essential to control what you can by being prepared.
Probate, taxes and the estate
Impressions can be deceiving, so it’s wise to temper your expectations. The reality is you could wind up with a smaller inheritance – perhaps much smaller – than you thought. Two culprits are probate fees and income taxes.
The good news? When designated beneficiaries are named, certain property like registered accounts and life insurance policies bypass the deceased’s estate, avoiding probate. The same is true for property held jointly with right of survivorship. But for assets not exempt, probate fees can quickly add up, running into the thousands of dollars for a modest estate. In your own planning, be aware that strategies to get around probate can have unintended consequences, including potential inequity between beneficiaries for example, so talk to your advisor about the best approach for your circumstances.
Even if property is immune from probate, there’s still the prospect of having a sudden income tax bill to pay before any funds are released to beneficiaries.
At death, property is generally deemed disposed of at fair market value. In most situations, that will include adding previously tax-sheltered RRSP or RRIF balances to the deceased’s income on their final tax return. With a top marginal tax rate of 47.7% in BC, the value of registered plans, as well as accrued capital gains on a rental home or investment accounts can take a major hit.
There are important exceptions. A home passed down which had been a principal residence isn’t taxed before changing hands. And, while accrued interest may be taxable for the estate, the capital held in cash and GICs in a regular account won’t be. If you’re a spouse or common-law partner who’s receiving assets, one choice is to opt for a tax-free rollover which lets you inherit property without immediate tax consequences.
Once the estate is distributed, be aware there could be restrictions, spelled out in the will or through a trust, which may affect access to the bequest, or how you’re able to use or invest it. In some cases this may turn out to be beneficial, such as if family disagreements arise over the legacy.
Setting your priorities
It’s common for an inheritance to be tied up in feelings of sadness and loss. That’s why most experts agree it’s prudent not to rush ahead. Wait a few months before making any major decisions, particularly if the bequest has the potential to rewrite your financial life.
The key is not to let immediate wants, or anxiety over dealing with the money, distract you from putting at least some of that wealth toward meeting your longer-term objectives.
When you’re ready, think about your goals. Could your retirement savings use a boost? It might be an ideal time to take advantage of any RRSP and TFSA contribution room you have available. What about your kids’ RESPs? If you’re carrying high-rate debt like a credit card balance, paying it off can deliver a financial benefit that’s hard to beat, and it’s guaranteed.
Reviewing your investment plan
A small inheritance can be simply rolled into your current investment strategy. But, a sizeable gift should prompt you to take a fresh look at your approach, including your goals, time horizon and risk tolerance. Any, or all, of these elements could change.
For example, with the extra capital, you may not need the same growth rate on your savings as before to reach your objectives, letting you dial back the risk level in your portfolio. That would mean shifting more of your asset allocation toward bonds and cash, and away from equities. On the other hand, you might want to leverage your added resources to accomplish more, leading you to get aggressive with your targets. Or, you could stay focused on achieving your current goals, but aim to do so in less time.
Assume your bequest will include existing investments, not just cash. You must then weigh the merits of each holding and decide whether to keep it in your portfolio.
Remember, you’re responsible for future taxes on wealth you inherit, so if you decide to turn around and shed assets there could be tax consequences. Say you’ve taken title to your parent’s home which had been a principal residence for them. If you already have a property so-designated, then their home becomes taxable property in your hands and subject to capital gains for the period you owned it. That said, a one-time tax concern shouldn’t be a reason to hold on to an asset if keeping it compromises your long-term plan.
A little at a time or all at once?
Reviewing your investment strategy is sure to raise a fundamental question: should you invest new money a little at a time or all at once? It depends.
When comparing investment returns, studies conclude that in general investing a lump-sum wins out over committing cash in smaller increments, or dollar-cost averaging (DCA).
In a recent analysis, Vanguard looked at the performance of different stock and bond allocations over rolling 10-year periods from 1926 through 2011 under each strategy.2 They found that lump-sum investing outperformed DCA across various scenarios.3
Assuming a 60/40 stock/bond split and a DCA strategy where money was added to a portfolio over 12 months, lump-sum investing won out two-thirds of the time. The divergence was greater still when money was averaged in over a longer span. A key reason? Vanguard observes that, on average, returns on stocks and bonds outpaced cash over the periods examined, so holding cash, which is inherent in a DCA strategy, dragged down performance.
If markets stick to their historical pattern of positive returns most years, the message is it’s smart to put money to work as soon as possible to maximize growth. But investment performance isn’t usually the sole consideration; there’s also risk to factor in.
Say you commit all your cash just before the market turns bearish. It’s safe to say you’d regret adopting an invest-it-all-at-once mentality. Dollar-cost averaging, however, spreads out entry to the market at multiple points, eliminating the chance of making a big bet at the wrong time. Plus, in a declining market DCA lets you purchase more shares as prices fall. Another benefit? Flexibility. You have new money ready to take advantage of emerging opportunities or better deal with unexpected expenses.
The bottom line is if you have a long investment horizon and are prepared to ride out any short-term volatility, odds are lump-sum investing will generate superior returns. Conversely, if your priority is to mitigate downside risk for greater peace of mind, dollar-cost averaging may be the better choice.
Implications for your estate plan
Not only can an inheritance have a significant impact on your investment strategy, it can do the same to your estate plan.
Do you want to increase the amount of wealth you leave each heir or broaden your group of beneficiaries? What about gifts to charity? If you’ve set up trusts, say for minor children, review those arrangements given your new circumstances.
Because they now have greater resources at their disposal, people inheriting wealth can sometimes fall into the trap of cancelling their life insurance policies prematurely. The truth is holding more assets could make having the right life insurance coverage more important than ever.
Life insurance proceeds provide valuable liquidity for your estate. That helps cover any taxes owing when you die, leaving more of your legacy in the hands of your loved ones, not the governments’. Without proper planning, your heirs may have to scramble to come up with the cash needed to settle your obligations, including selling sentimental assets, like a family vacation home, you’d rather leave to them.
Talk to us first
The gift of an inheritance may be something you won’t see again. That’s why you want to be sure it’s handled properly.
Working with you to revise your investment strategy, update your estate plan or put the right insurance protection in place – it’s all part of how we help you manage your legacy, for today, tomorrow, and for the next generation. Speak with your BlueShore Financial advisor to learn more.