This episode explores what to do when you receive an inheritance, and the options that you have when you invest. We consider paying off a mortgage and investing in and out of superannuation.

Other episodes where we speak about inheritances include:

Your options when you inherit a house

How to incorporate an expected inheritance into a financial plan

The documents you need to protect your assets

 

Listen on:

Get more of Morningstar's articles in your inbox

 

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: All right, Shani, you have a dream. And this is not like Martin Luther King's dream. Like nobody's going to invite you to speak off the Lincoln Memorial, right?

Jayamanne: No, although two days ago, I did have a dream about Alexander Graham Bell. I don't know what's going through my mind.

LaMonica: We'll just leave that one for now. But your dream is you want to own a flower shop/wine bar. And presumably you'll just drink wine and arrange flowers and then like occasionally sell something to a customer.

Jayamanne: I do that most weekends now. I did a floristry course.

LaMonica: And you told me you're very good.

Jayamanne: I think I'm getting better.

LaMonica: And do you want me to talk about your big fault? Or do you want to talk about it in terms of flower arrangement?

Jayamanne: You can talk about it.

LaMonica: So apparently, and I've never taken a flower arranging course, they give you all these different flowers and some of the filler stuff and some of the main flowers. I'm sure there's better terminology for this. And so most people selectively, you know, pick things to put into a bouquet. Shani feels bad for the flowers that were not picked. So whether that is, I mean, they were all picked, I guess, but bad for the flowers that like maybe don't look that good. And most people discard. So she puts everything into her bouquet.

Jayamanne: That's a very nice perspective of what happens. But it's actually because I just want the most value for money. All of these flowers have been given to me. So I might as well use them.

LaMonica: Yeah, but it's like a sunk cost. You've paid for the course.

Jayamanne: Yeah. But I just want to use all the flowers.

LaMonica: Okay.

Jayamanne: I feel like that's very successful for a floristry business, because you're giving people value for money. They're getting a lot more flowers. It might be ugly, but you're getting a lot more flowers. It's bulk.

LaMonica: Next time somebody gets you flowers, are you going to say, that's a lot of flowers? You're going to say that's beautiful?

Jayamanne: Maybe both.

LaMonica: Well, there you go. A challenge for anyone getting you flowers. She wants a lot of them and it has to be beautiful. Alright, we're going to get back to dreams. Like one way to, I guess, talk about your dream, right? It's kind of like a when I have money dream. You know, and a lot of people, and I kind of like that terminology better. A lot of people, it's kind of like when I win the lottery, right? That's sort of their dream. And I like the terminology around when I have money, because this podcast is for saving and investing, so that hopefully everyone listening has 'money' at some point.

Jayamanne: And I do think that is a better attitude to have. Most of our podcasts are about the slow and steady accumulation of wealth, but we're going to take a bit of a different spin on things today, the sudden acquisition of wealth. One way to do this is to win the lottery. But in a stat that I think most people have heard of, or some variation of it, the US National Endowment for Financial Education found that 70% of lottery winners do go bankrupt within the first five years.

LaMonica: Yeah, which is kind of interesting. I assume you've heard that before. Does that surprise you? Not surprise you?

Jayamanne: I mean, not really.

LaMonica: Because like the interesting thing is also like not only do these people lose all of the money, they, and obviously they come from different financial positions, but not only do they lose all of the money that they won in the lottery, they've also lost all of the money they have had and somehow went into enough debt that they had to declare bankruptcy. So yeah, it's pretty crazy.

Jayamanne: As you've probably guessed, we're not basing a whole episode on lottery winners, but there are other windfalls that investors can receive. And it could be an inheritance which we've heard a lot about with the ongoing intergenerational wealth transfer occurring. It could be selling a small business either way. We want to make sure that you don't squander this windfall if you're lucky enough to receive it.

LaMonica: And we did an episode on the intergenerational transfer of wealth, but as a reminder, $3.5 trillion in Australia is expected to be passed down. Now, one thing that we should notice at the average age, and we're going to talk about this a lot today, the average age to receive an inheritance is 50 according to the Productivity Commission. And that same report, the average inheritance was $125,000. Now, this data is a little bit old, it's from 2019. So it's likely higher today.

Jayamanne: So we're going to walk through some of the thoughts on inheritances. And unsurprisingly, we are going to encourage everyone to be really thoughtful about how you approach it.

LaMonica: Yes, although it'd be more fun if we just said…

Jayamanne: Here's what you spend it on.

LaMonica: Just blow it. Send it to us. We'll blow it. But I think we wanted to speak a little, I guess philosophically about inheritance. So, we've all heard these stories, your mysterious third cousin that you've never met leaves you all this money, and it's a complete surprise. But that's not really how life works, at least for most people. It's more likely that you know or suspect that you're going to get an inheritance. And knowing you're going to get one can lead to some really poor financial decisions.

Jayamanne: There was a guy that I used to work with. And he used to mow this old guy's lawn on the street that he lived on. And so he ended up getting the whole inheritance. His children didn't get anything. He just got it for mowing the lawn. Him and his brothers, his brothers went and mowed the lawn.

LaMonica: Yeah, I mean, I don't know how this works, because we did a whole episode where you can challenge basically anyone's will. And that seems like a really easy one to challenge.

Jayamanne: Yeah. So mow your neighbor's lawn. See what happens.

LaMonica: Okay, I live in an apartment. What am I supposed to do?

Jayamanne: I've seen crazy things in Surry Hills and people have gone out and mowing the concrete.

LaMonica: Okay, well, there we go.

Jayamanne: But what can happen is that people mentally account for a windfall. And the attitude can be that if you don't need to worry about saving for retirement or paying off a mortgage or some credit card debt, because at some point you will be getting an inheritance. And this leads to all sorts of problems.

LaMonica: Yeah. And I think the first, the first problem is, of course, people are living a lot longer. So that is a couple of different implications. The first is that you'll likely get an inheritance later in life. We said the average age, at least back in 2019 was 50, that's going to keep increasing. And of course, second is the longer that somebody lives, especially if they have a chronic illness, the more money they're going to spend. So of course, your inheritance is less.

Jayamanne: And that means that as the years pass, you might be justifying decision after decision based on this upcoming inheritance. And in fact, you might have mentally accounted for the inheritance so many times that you spent it over and over again.

LaMonica: And if you have put yourself in a terrible financial position and then get a smaller inheritance than you expect later in life, you might not be able to dig your way out of that hole that you put yourself into.

Jayamanne: So if you can get yourself in a good financial position, the inheritance whenever it comes and whatever amount it comes in, it can be transformative. It is always better to be in a good financial shape because it gives you more options in life. It also gives you more options with an inheritance and options are always a good thing.

LaMonica: All right. Now, we've done a couple episodes on inheritance. Now, we've done sort of technical ones on the tax implications of inheriting a house, inheriting super. So we're going to skip that whole part today. But of course, you can go back, listen to those episodes. You've also written articles on them as well, Shani.

Jayamanne: I have if you'd prefer to read that unsurprisingly, we are going to get into the investment side of things. But first, a reminder that two things should be front of mind if you do receive an inheritance.

LaMonica: Yeah, neither of these, of course, are fun. This isn't going to the casino, which is one way to blow it.

Jayamanne: That's true. The first is to pay off any non-mortgage or HECS debt that you do have. Chances are the interest rate on that debt is way higher than any return you could ever earn. And the second is to make sure that you have an adequate emergency fund. Now that we've gotten that out of the way, it's time to get into the fun stuff, which once again is not going to the casino.

LaMonica: So the first thing to do, and you've probably heard this a lot from us, is to take stock of where you are. So for some people that follow the process that we advocate through this podcast or things we put on our website, this should be a really easy exercise. So in that case, you will have defined your goal, you know what you need to save, you know the return you need to achieve your goals, and you have an investment strategy.

Jayamanne: And there is a danger from any windfall that economist Richard Thaler identified in his work on mental accounting. And perhaps this accounts for the issue with lottery winners that we talked about earlier. According to Thaler, a windfall situation like an inheritance, but even a bonus or a tax refund, drives more biases.

LaMonica: And basically his finding was that people treat this money that comes in as a windfall differently than if they just received it through work. So people are more likely to splurge with a windfall than they are with money that comes through a paycheck. Well, money is money. It's all the same. So just be aware of this and just make sure that you are not mentally framing this differently. Because of course, that can lead to the dangers that you blow at least a portion of your inheritance or any other windfall you receive, like a bonus or tax refund. So that is why we're just encouraging you to go through this process for any money that you get.

Jayamanne: And for people that have defined goals and an investment strategy, you have a leg up. If you're one of those people, then you will know if you are behind or ahead. If you're behind, part of your inheritance could go to catching up. If you're on track or ahead, you could use the inheritance to get further ahead. And this could take all sorts of forms. Perhaps your goal is hitting a certain number in investments. Perhaps your goal is paying off your mortgage before retirement. So we'll get into some specifics in a bit.

LaMonica: You could also, of course, be someone who has no idea where you are. So you don't have a goal. You don't have an investment strategy. You're just kind of drifting aimlessly. This should be a wake up call to get your house in order. So we have so much material that of course can help you do this and set yourself up for success. So just relax, go through the process of goal setting and setting up an investment strategy. Don't do anything hastily. Just having the money sit in a bank account for a couple months is far better than doing something impulsive and once again, blowing the windfall.

William Ton: I'm Will, producer of Investing Compass and here are this week's must reads on Morningstar.com.au. Mark's Unconventional Wisdom column looks at a study showing investors that own passive products get lower returns. He looks at why this is the case and how investors can maximize their outcome. In a reader requested edition of Bookworm, Joseph explored a simple stock valuation method that features in one of his favorite investing books. By putting the formula to work on an ASX company with household names, Joseph was reminded that even the simplest valuation tools are in fact highly complex. Many young investors find that purchasing a home is simply out of reach. They find out that they are struggling with cost of living and have minimal amounts to contribute towards investment. Shani's Future Focus runs through a framework that looks at different aspects of your life where you can still set financial goals to help your future self. As days pass, young Aussies are straying further from being able to buy their own home. Amidst (election) noise, consistent house price rises and slowing wage growth, it appears there is no end in sight for Australia's housing crisis. Sim's article explores whether millennials can afford to buy a home and what salary they will need to achieve this goal. To read these articles and more, head over to the episode notes. Now it's back to Mark and Shani.

Jayamanne: So let's walk through some different options for the money and how you can think about them. Obviously, spending all or part of your inheritance is an option, but we're going to focus on helping with a financial goal. So there are three main options. Option one is property. You could use it to pay down your mortgage or the mortgage on an investment property. Option two is that you could add it to super. Option three is that you could save or invest in it outside of super.

LaMonica: And the goal, of course, is to put the money in the best place based on your goals and what you want to accomplish. So we'll go through how you should potentially think about this. But one of the biggest drivers for what you do with the money is your marginal tax rate. And this is a generalization. But if you receive your inheritance around 50, which we said, of course, was the average age, it means you are likely in your peak earning years, which may mean that you are at the highest marginal tax rate that you'll ever be at during your life.

Jayamanne: And the first consideration is how much of a mortgage that you have left. And we've mentioned this on the podcast before, but with a mortgage, there is a huge advantage to paying it off. The reason for that is pretty simple. Generally, a mortgage is the biggest expense for most people and getting rid of that expense is great. It means you need less money for retirement and more Australians than ever are retiring with mortgages. You just don't want to be one of them. Also, it frees up cash flow that you can direct to other places like into super or investments outside of super. So it is hard to beat that option. But if your inheritance falls short of what is left on your mortgage, it does change the equation. Paying down your mortgage still has benefits as you do save on interest. However, now those benefits need to be balanced with the other options available for your money. And this is typically where people get into the mortgage versus investing debate.

LaMonica: And the first point is that from a conventional wisdom standpoint, we often hear that the level of interest rates that you're paying is the amount that you need to beat with any other investment. So basically, that's the hurdle rate. Well, this is wrong. So the reason it's wrong is because it doesn't take taxes into account. And as investors, we all need to worry about how much we have left over, of course, after taxes.

Jayamanne: So with a primary residence, you're exempt from capital gains taxes. That's not true from an investment perspective. So we will look at the hurdle rate or how much you need to make from an investment account to break even. The first thing to note is that the mortgage rate does matter. And in this case, we're going to use 6% as an example. And it is a nice round number and it's pretty close to where we are right now.

LaMonica: And there are a couple other assumptions in here that everyone should be aware of for any gains on anything that you invest, we've applied a 25% discount to total gains. This accounts for some long term capital gains, which are discounted 50% from your marginal tax rate, some short term capital gains, which do not receive that discount and then dividend or interest income, which is also taxed at your full marginal tax rate. So this is an estimate, but we think it's kind of ballpark.

Jayamanne: Let's start out with a 45% marginal tax rate. And that's for individuals that make more than $190,000 a year. If you were to invest that money instead and invest it outside of super, the hurdle rate for that is 8.3%. So what do you think about that, Mark?

LaMonica: I mean, I think that's pretty high. And long term share markets, of course, have exceeded that. But many investors, both professionals and just individuals, have gotten returns well less than the index. So I would think twice about that. It's going to be challenging.

Jayamanne: Now, if you're able to make a concessional contribution to super, things look very different. That means that instead of a 45% marginal tax rate, you're paying 15% for the super contributions and you're getting a lower rate at 15% for any capital gains or dividends. The hurdle rate is now negative 0.66%. And that is because there is such a big tax savings between the high marginal tax rate and the 15% marginal tax rate.

LaMonica: Yeah, and I'm not exactly Warren Buffett, but I think I could beat that. Right? You could beat that with a term deposit. So that's pretty easy to do.

Jayamanne: The issue, of course, is that there are limits to concessional contributions, which may be challenging to meet if you happen to meet our profile of a person that's getting an inheritance around 50 and in the top marginal tax rate. But as a reminder, the limits in 2024, 2025 are 30,000. With a catch up provisions, you need to have less than 500,000 in super and you can use any unused concessional contributions from the last five years.

LaMonica: And if you're not eligible for concessional contributions, that puts you in non-concessional land. So that greatly increases the hurdle rate because you aren't getting the tax break on the difference between your marginal tax rate and then the 15% super rate of anything you put in there. However, you still get a lower rate on capital gains and income. In this case, the non-concessional hurdle rate is the same across all tax brackets. It's 6.60%. So what do you think about that as a hurdle rate, Shani?

Jayamanne: That one's a bit more doable over the long term. And we also want to remind you of the rules for non-concessional contributions. The non-concessional contributions cap is $120,000. So if you're under 75 years old, you can take advantage of that bring forward arrangement. You also have to have less than $1.66 million. And if you have that, you can use three years of that cap, which means you could put $360,000 into super.

LaMonica: This is like your favorite, Shani, explaining super rules.

Jayamanne: Is it?

LaMonica: Yes.

Jayamanne: Okay.

LaMonica: I mean, you're pretty into it. Not as much as going to paycalculator.com.

Jayamanne: I do like doing that.

LaMonica: Yes. And of course, as we've talked about before on here, transferring money out of your account prior to your paycheck going in.

Jayamanne: Sometimes I can't wait, but...

LaMonica: Because you're the super queen, anything else we should add here?

Jayamanne: We could go through the same exercise over and over again for all of the different marginal tax rates. What do you think?

LaMonica: That seems like a lot.

Jayamanne: Okay. So maybe calculate them yourselves or you can email Mark and Mark can do it for you instead. But all of these scenarios are premised on selling your house. So we've assumed the house has appreciated by 7.1% a year because that is the annual appreciation in Sydney over the last 10 years to the end of 2023. But before we explain why this matters, I am curious if you think that's going to happen again, Mark.

LaMonica: Well, I mean, I should state that I do not have a dog in this fight, right? I don't own my home. I'm not looking to buy one. So I don't know. Do you think that makes me overly pessimistic or just neutral and unbiased?

Jayamanne: Don't know. You tell me. Let's see what your answer is.

LaMonica: Because Shani bought a home and instantly became captain homeowner.

Jayamanne: What does that mean?

LaMonica: You were on the barricades with the rest of the millennials complaining about housing prices and government policies. And then like...

Jayamanne: Did I not just write an article about how unfair it is for millennials?

LaMonica: No, you did. But I'm talking about our personal interactions. Shani calls the council every day and like complains about stuff. There was a leaf on her street and she called the council. It's been kind of crazy.

Jayamanne: Mark is exaggerating. There was a couch that was left on our street for probably nine months.

LaMonica: Which people in the neighborhood were using to relax?

Jayamanne: We won't say what they were actually doing on it on this podcast, but yes.

LaMonica: I mean, you can say that homeless people in your neighborhood were using drugs, Shani.

Jayamanne: Let's move on.

LaMonica: Okay. Anyway, back to the house. Yeah, I think there's no way that's happening again. I mean, just simply prices have appreciated so much higher than wage growth for so long. Yeah, I don't know how that can keep happening. But anyway, that's my two cents. We use that as an assumption just to be very, I guess, in a way conservative with how we're calculating that hurdle rate.

Jayamanne: But I think more importantly, it is important to think of your own situation. Are you planning on selling your house? Are you planning on retiring in your house, living in it forever? If you aren't planning on selling your home, I would say the only thing that matters is getting to the point that you completely own your home outright.

LaMonica: Yeah, I completely agree. What about you, Shani? Are you in that house forever?

Jayamanne: I think so until I can't climb the stairs anymore and then I'll probably have to move.

LaMonica: Okay, so that will be at least a couple more years.

Jayamanne: Yes.So how does our advice line up with what people are doing? Well, Perpetual surveyed 3,000 Australians who inherited money and asked them what they were going to do. 30% of people said they would invest it, 28% said they'd pay off their mortgage, and 19% would share it with family. The rest said buy a car, put it in a term deposit, and go on holiday.

LaMonica: Do you think 19% is high for the amount of people that are sharing this with their family?

Jayamanne: That's not going to be your choice?

LaMonica: I mean, it depends what you -- I'd obviously share it with my wife, but I don't have any other family. The only family I have is people that I would inherit the money from. So I don't know. I could share my inheritance with you, Shani. But we've got this thing, right, where you said on the previous that I should put you in your will, on that will episode that we did. And I think that's the only reason you're still hanging out with me. So I don't want to just give it to you immediately.

Jayamanne: Now, you know my secret.

LaMonica: Apparently.

Jayamanne: So what do you do if you're younger? We were assuming that somebody was around the average age of an inheritance at 50. So what do you do if you're in your mid-20s or mid-30s?

LaMonica: Yeah, I mean, I think a couple of things. So the first is at the level of wealth in this country, and most countries is skewed upwards. So basically, as people are older, they have more wealth. And this isn't some sort of conspiracy theory, right? It's just math. That's how compounding works. But that means that the average 50-year-old is going to be in a lot better shape than the average, let's say 25 to 35-year-olds. That means that there may be a fair amount of financial pressure just getting by. So if you are in debt, of course, by all means, pay that off. But also, we really want to focus on not squandering that. So $100,000 is worth a hell of a lot more to a 25-year-old than a 50-year-old. And that windfall can change your life if you're smart with it. So once again, take your time and don't blow that.

Jayamanne: I will say that Mark's point stands. At a 7% return, $100,000 at 25 turns into $1.5 million at 65. $100,000 at 50 turns into $275,000 at 65 with the same return.

LaMonica: So why don't you give us some final wisdom on inheritance, Shani? We're getting to the end of the episode.

Jayamanne: All right. So we're all busy and we all procrastinate. Many people, including some of our listeners, have put off defining goals and coming up with an investment strategy. And we think it's a great investment of your time, but we get it. Life events like an inheritance can be an impetus to make some positive changes. It is a great time to put some structure around the way you invest.

LaMonica: And of course, we want to acknowledge something we've ignored in a lot of this episode, that an inheritance obviously comes on the back of losing a loved one. And that can be a really stressful time and really trying time emotionally. So once again, we said this a couple of times, but don't rush into anything. Drop the cash in a bank account, wait until you can figure it out. And when you're in, I guess, the right headspace to make good decisions. And with that, we can give you back the rest of your day, as we always say at the end of meetings, for some reason. You can do that listening to old episodes of this podcast or, Shani, you have a new hit column, Future Focus. People can read that.

Jayamanne: You have a new column too.

LaMonica: I do, but hit column, Future Focus. But anyway, thank you very much for listening. My email address is in the show notes, so send an email if you have questions or comments.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)