When you receive an inheritance, it can be difficult to decide what to do with it. It’s probably one of the few windfalls you’ll receive in your life. You want to be respectful of the gift you’ve been given, but also use it to its fullest advantage. So how should you use your inheritance?
If you’ve inherited any property (for example, a home, vehicles, or valuables), you’ll need to decide whether to use or sell it. When making those decisions, think about whether you’ll get use out of the property and whether you can afford to maintain it. If you inherit a home, there are ongoing costs such as maintenance and property taxes that will need to be paid. If it’s not practical to keep the property, it’s probably better to sell it sooner than later to limit the expense of holding it.
If you’re worried about taxes, you’ll be happy to know there is no inheritance tax in Canada; rather the government treats the estate as if it had been sold, and taxes the estate before it’s bequeathed. You may incur capital gains tax after selling any property you’ve inherited, but the amount will be based on any increase in value since the property came into your possession. This adds to the argument for a quick sale of any property you don’t intend to use.
After you’ve liquidated the property (or if you’ve inherited a large amount of cash), the best thing to do is to pay off your debt. While it can feel like a disrespectful use of inherited money, it’s actually the best thing you can do to enhance your financial well-being. Interest rates on consumer debt tend to be much higher than the returns you can earn by investing, so the best choice for the long run is almost always to pay off debt first.
For example, if you owe $10,000 on your credit cards and you’re paying an interest rate of 19.99%, you’ll pay $1,844 in interest in the first year (assuming you make a payment of $300 a month). If you invest $10,000 and have a 6% annual rate of return, you’ll only earn $600 in a year. As you can see, you’ll have a lot more money at the end of the year if you use the money to clear your debt than if you continue to carry debt and invest your money elsewhere.
Once you’ve paid off your debt, you will probably want to invest whatever’s left over. There are a couple options available that can shelter your investments from tax: TFSAs and RRSPs.
Let’s start with the TFSA. This is a tax shelter that can hold various types of investments. You can place cash, GICs, bonds, stocks, mutual funds, and exchange-traded funds (ETFs) in a TFSA. When you hold investments in a TFSA, you don’t pay tax on the interest or income you earn, and you don’t pay tax on any withdrawals.
But before you pour your entire inheritance into a TFSA, you should be aware of the TFSA rules. Most notable is the contribution limit. There’s an annual limit for all Canadians that’s set by the government (in 2017, the TFSA contribution limit is $5,500). Unused amounts carry forward even if you don’t open a TFSA, so chances are you have a significant amount of contribution room built up. If you were over 18 when TFSAs were introduced in 2009 and you’ve never deposited money in a TFSA, you currently have $52,000 in contribution room available (check out our TFSA room calculator to instantly determine your limit for the current calendar year).
TFSAs are a good choice for general investments because you can take money out at any time without penalty. And you get your contribution room back in the year following your withdrawal. This is especially helpful if you want to invest your inheritance for a shorter time period while you decide on the best use of the money.
Another good choice to place your inheritance is an RRSP. Like TFSAs, you’re allowed to various types of investments. When you make an RRSP contribution, the money you contribute is deducted from your taxable income for the year. But you have to pay income tax when you make an RRSP withdrawal. The advantage to this is you’re likely to be in a much lower tax bracket in retirement compared to your highest-earning years. You’ll likely pay much less tax on your withdrawals in retirement than you would have paid on the income in the year you earned it.
However, RRSPs are mostly meant for retirement savings. So if you want to be able to access your money for other reasons—such as to pay for a child’s education—an RRSP won’t offer the flexibility you need to withdraw at your leisure.
If you need help deciding how to invest your money, fee-only investment advisors can help you make the right decisions. They can look at your overall financial situation and goals, and make recommendations about what kinds of investments to choose (and what accounts to use) so you can make the best use of your inheritance.
The bottom line
An inheritance is a gift, but that doesn’t mean you have to use it like your birthday money. The best way to use your inheritance is to make smart financial decisions that will give you the best outcomes for the future.