Has a relative or friend left you money in their will? If you’re not sure what to do with it, read our step-by-step guide to how to make the most of that extra cash
Perhaps you are thinking of using your inheritance windfall to pay off your mortgage or would rather invest it or use the opportunity to help others. Your approach will depend on how much you receive and your circumstances, but before you get carried away, here are the main points to consider.
Don’t rush into a decision
The average inheritance is £11,000, peaking at £33,000 for people approaching retirement, according to the Office for National Statistics, while more than half of us expect one, according to research by the Co-op. However, as welcome as a cash lump sum might be, inheriting money is bittersweet as it often comes from the loss of a loved one. Grief can cloud your judgement and you will no doubt want to do justice to the person who has left you the money and worked hard to earn it, so never rush into financial decisions.
“Just like you should never go shopping hungry, don’t walk into a travel agent after receiving an inheritance,”warns Charlie Parker at wealth management firm Sanlam UK. “It may be tempting to change your immediate financial circumstances but before doing so, ask yourself: ‘How can this money be deployed over my lifetime’, remembering this may never happen to you again.”
“Don’t make a sudden decision - you may never get another windfall”
Savings of up to £85,000 are protected in most UK bank and building society accounts if something goes wrong, under the Financial Services Compensation Scheme. However, in the case of an inheritance, a balance of up to £1 million is protected for six months. This means that you don’t have to move your money straight away over fears it could be vulnerable in the unlikely event that your bank of building society goes bust.
When receiving unexpected money, it’s a good idea to seek advice to ensure you make the best financial decisions.
“Expect to pay from around £500 for advice but this depends on what services your adviser performs for you,” says Karen Barrett at Unbiased. “Your first meeting is usually free, so you can find out exactly what your adviser can offer you and decide whether to proceed. Find a local adviser on Unbiased.co.uk.”
Start by repaying any money you owe – for example, on credit cards or personal loans.
Jamie Smith-Thompson, managing director of financial planner Portafina, says: “A loan or credit card balance with a high interest rate can feel like a burden, which is all the more reason why it should always be the first to go. Once cleared, it saves you paying back more than you owe in interest and increases your disposable income.”
When prioritising which debts to pay, start with the smallest value first and those incurring the most interest.
Boost your savings
Your next priority should be an emergency fund of three to six months’ expenditure, so you can handle unexpected costs. Then a mix of savings products will work best – some easy-access and some fixed-rate savings between one and five years.
“Don’t assume you have to stick it all in Cash Isa accounts,” says Andrew Hagger, founder of personal finance website MoneyComms.co.uk.
“Everyone now has a personal savings allowance (PSA), which means as a basic-rate tax payer you can earn up to £1,000 in interest a year without paying any tax on it – £500 for higher-rate taxpayers. Unfortunately, banks and building societies offer lower rates on Cash Isas than on standard savings accounts, another reason not to go totally down the Isa route.
“To give you an idea of amount of interest you could earn and stay within PSA limits, if you had £45,000 in an account paying 2.2% you would earn £990 interest in a year,” he adds.
Minimise your mortgage
An inheritance can be life-changing for those wanting to get on the property ladder or pay off a chunk of their mortgage.
But be aware of your lender’s overpayment limits or you could incur an early redemption charge (ERC), says Ray Boulger, mortgage expert at John Charcol.
Brits reveal their inheritance goals
- Save it
- Invest it
- Don’t know
- Pass it to children or grandchildren, pay off the mortgage or go on holiday
- Home improvements
Source: Co-op Legal Services, October 2018
“Most mortgages allow overpayments of up to 10% a year without incurring an early repayment charge. Therefore, if you happen to receive the windfall at the right time of the year you might be able to repay 20% within a short space of time by using two of the annual ERC free allowances. However, timing varies between lenders, so check first,” he says.
If the windfall is large enough to exceed the ERC-free limit Mr Boulger says it may still be worth overpaying the mortgage, depending on how much the ERC is. “In most cases it will be between 1% and 5%. Once the ERC period has finished (usually when the fixed or discounted rate does) there are normally no limits on overpayment.”
If you have an offset mortgage, you can usually pay as much into your linked offset savings or current account as you like without ERCs, saving on future interest payments.
If you pay off your mortgage, consider cancelling some of your life insurance – assuming you don’t have dependents. If there are people who are financially dependent on you, use freed-up cash to buy life insurance, plus protection in case accident or illness means you are unable to work.
Invest your money
You can invest any money you won’t need for the next five to 10 years in the stock market. Risk is involved but investing over a longer time period gives you time to ride out fluctuations and take advantage of long-term growth. As a result, investments have far more growth potential than money in a savings account.
Invest in a number of funds to spread risk. “Consider a low-cost index tracker, such as Legal & General UK Index, which aims to follow the performance of the UK stock market,” says Sarah Coles, personal finance analyst at Hargreaves Lansdown. “Or opt for actively managed funds, where the fund manager uses their expertise to try to outperform the market. In the UK, we like AXA Framlington UK or Rathbones Income. And if you want to take advantage of growth wherever it is in the world, we like Lindsell Train Global Equity.”
Invest to enjoy far more growth potential than cash in a savings account
The first £20,000 of any investments each year should be in an Isa, which means any gains are free of tax, and any dividends are tax free, too.
Moneywise First 50 Funds can be a good place to start (see Moneywise.co.uk/first-50-funds).
Help out loved ones
Receiving an inheritance offers the chance to help other family members. For example, Mr Smith-Thompson says you can use the Lifetime Isa to help children or grandchildren buy their first home.
“The government will give a 25% bonus on contributions to this and you can save up to £4,000 a year. Or consider a Help to Buy Isa, which includes a bonus of up to £3,000 towards the deposit for a new home. You can also set up a pension for a child. “This offers tax relief on contributions and any growth on the lump sum is not taxed either,” he explains.
Older people who inherit and don’t necessarily need the money may want to pass on the gift. If you act within two years of the deceased’s death, you can draw up a deed of variation to redirect the gift to your chosen beneficiary. This avoids the money becoming part of your estate and subject to inheritance tax (IHT).
What is more, you can make gifts of up to £3,000 in total each year that will fall outside your estate for IHT purposes. You can also give gifts of any size and, so long as you live for at least seven years after making the gift, it will fall outside your estate for tax purposes.
Get professional advice for any money you wish to pass on and protect beneficiaries by making or updating your will.
Pep up your pension
Kate Smith, head of pensions at investment firm Aegon, shares her top tips for boosting your retirement income:
If you don’t have any pension savings, putting some of your windfall into a pension will set you up for a good start in building savings for later life. This is because you get tax relief on your pension at the highest rate of income tax you pay, ie at 20%, 40% or 45%. You are allowed to pay up to £40,000 a year based on your earnings into a pension up to your 75th birthday and still get tax relief.
If you’re employed, you can pay some of your inheritance into your workplace pension and get tax relief on the amount you pay in. Your employer might even match some or all of your contributions.
If you’re self-employed, you will need to find your own pension plan. A financial adviser can help you with this or you can start a Self Invested Personal Pension (Sipp) on an investing platform (see our feature on page 73 for how to pick the lowest-cost Sipp platform for you).
If you don’t work, you can pay into a pension, but you’re limited to £3,600 a year, including tax relief. For a basic-rate taxpayer this means you can pay in £2,880 and get a government top-up of £720. You could drip-feed your inheritance into a pension over a number of years.
Take advantage of carry forward rules. If you have already filled up your annual allowance for this tax year, you can carry forward any unused annual allowance from the previous three tax years. This rule gives you the flexibility to pay in large occasional contributions into your pension such as inheritance payments, and still get tax relief. It is possible to pay in more, but you won’t benefit from tax relief.
If you’re retired, check your pension plan to see if you can add lump sums to your pot to boost your retirement income. The rules are more restrictive if you have started to take a ‘flexi-access’ income, in which case you will have a much lower pension annual allowance of only £4,000 a year. Check whether these rules apply before you pay large inheritance payments into your pension. One tip is to spread pension contributions over a number of years up to age 75.
Sarah Jagger is a freelance journalist, writing for magazines such as Yours, Essentials and Good Housekeeping