Is Inheritance a Part of Your Net Worth?

The “Great Wealth Transfer” is coming — the transfer of money from the frugal baby boomers to their spendthrift millennial children. Some of us are blessed enough to anticipate some form of this inheritance. Whether it is a small sum which would, nevertheless, be good to have, or sizable assets, dealing with inheritance is always tricky. Keep in mind, the median inheritance is $69000, which is nothing to scoff at.

There is no other future income which is this uncertain. Sure, you can say business income is. But you would, as a prudent businessman, have some idea regarding the kinds of inflows or outflows that come with the territory. Inheritance, on the other hand, is in a completely different league — you don't know whether you will receive a few dollars or a gigantic portfolio of real estate spanning twenty countries. Also, it is something we do not want to think about as far as possible, given that it is something that comes contingent on a very personal loss.

But the ostrich mentality of pretending that life will continue ad infinitum isn’t a very healthy way of deciding anything, let alone your financial life. So, how is this uncertainty to be dealt with?

There are two lines of thought around this, both on opposite ends of the spectrum:

1. Inheritance is a bonus, above and beyond what you yourself save and invest
2. Inheritance is a known asset, whose nature and quantum can be predicted with reasonable accuracy, and as such, should factor into your net worth calculation

As usual, the answer is somewhere in the middle. While I am not saying that these two ways of thinking are wrong, they are less than ideal in most cases.

The first line of thought, that of considering inheritance as a bonus and being blind to it till it is actually received, may be apt for a situation where there are multiple people eligible for the inheritance with no indication of where it might land, or where the inheritance is small enough or uncertain enough to not affect your net worth.

The second line of thought, on the other hand, would suit where details of the inheritance are well-known, and the distribution is also fairly certain.

But in other cases, there are significant disadvantages to taking such extreme stands. If no inheritance is considered, you may end up over-saving — which is not a bad thing, one could argue. But more crucially, you may end up being too heavy on certain assets. For example, if your parents will you two houses but you have also purchased one, your portfolio may become too heavy towards real estate and the return will certainly diverge from what you expect. Sure, you can always rebalance when you do end up inheriting, but you would have wasted those many years of getting the benefits of other asset classes.

On the other hand, the disadvantage of considering a detailed inheritance is too obvious to detail — you could very well end up falling flat on your face, with not enough savings to fund your expected life.

So, to avoid painful humiliation and regret, here is how you can factor an expected inheritance into your calculations:

1. Is there even going to be an inheritance worth factoring in?

This is the first and foremost question, which will determine whether you even need the rest of this article!

Granted, your parents may be wealthy. But life expectancies and the related medical costs are increasing. The national average cost of a private room in a nursing home was $102,200 per year. If you add the cost of certain now increasingly common diseases like cancer and Alzheimer’s, you are looking at a further $150,000 to $300,000 a year.

In addition, older adults usually (and rightfully so) tend to hold portfolios that are conservative. While that is great to protect their capital, the fact is that, by the time the inheritance manifests, its purchasing power would have fallen significantly.

Inheritances are also tricky in that they depend on interpersonal relationships. While you may not have a blowout fight with your parents, there are many other factors to consider. Your parents might believe that too much inheritance is unhealthy — a la Warren Buffet. They might have other priorities — for example, they may want to contribute to a grandchild’s education instead of simply handing over the money to you. Or they may want to donate and not leave behind anything.

It is always a good idea to have a calculated guess as to whether you are really going to inherit anything at all. A conversation with the parents might also help — though money and death are both taboo subjects in our society, a practical approach can save much heartburn and misunderstanding down the road.

2. What is the form of this inheritance?

Inheritance can come in various forms. While the wealthy inherit trusts and LLCs, the more modest among us could inherit stocks, bonds, homes, cars, or even cold, hard cash.

If you belong to the former category, please consult a financial advisor — you can afford it.

For the rest of us, things are simpler — and more difficult. Once you have established that you are going to receive something in inheritance, you need to broadly consider the form in which this will be passed on to you. Unfortunately, the only way to know this is to ask. But, if that is not an option given the status of your relationships, it is still not very difficult to estimate. After all, assets are usually visible, unless it is all socked away in an offshore account.

But how does the form matter? I would argue it is probably the most important factor, even more than the quantum — but more on this later.

3. How can the inheritance be maintained?

All inheritances require maintenance. Whether it be in the form of estate taxes, property taxes, or just usual repairs, no asset is a pure asset. It is important to mentally factor in the costs associated with an asset, before counting the unhatched eggs.

In fact, some assets would require so much maintenance that they aren’t even assets! I hope that isn’t the case with your inheritance, but do know that it is a possibility.

Once you have an idea of what the ‘net’ value of the asset could be — whether it is a lumpsum, as in the case of stocks or cash, or a recurring income like a rental property, you would be better placed to place this puzzle piece into your net worth.

4. How does it figure into your financial goals?

All of us have life goals. If you’re a smart one, you would have turned those into financial ones.

For example, I would love to own a house. That is a life goal. But figuring out how much down payment I can afford, and putting away a sum every month towards that payment, is a financial goal.

Other goals can be educating your children, owning a car, or putting together a retirement nest egg.

What you need to do now, is map your expected ‘net’ inheritance towards one of these goals. Here is how to do so:

The timing has to match. Inheritance is (hopefully) an income that you would expect some time down the road. So you certainly cannot map it to a financial goal that is short-term, for example, paying for your wedding next year. Ideally, the longer-term goals like retirement or kid’s college (if you have young kids or no kids at this point) are better suited.

The form of inheritance has to match. If you are expecting to inherit cash, you can apply it towards whatever you want. But if you inherit the family home, there is little chance of you liquidating it to pay for a car you’ve had your eye on. On the other hand, if you are expecting to inherit a rental property, you can factor it into your plan of having a few rental properties in your portfolio quite easily.

The frequency of inheritance has to match. If it is a rental property, it lends itself better to recurring or monthly goals, like paying off a mortgage. On the other hand, a lumpsum would be more suited towards a down payment.

The importance of the financial goal should be proportional to the certainty of the inheritance. I wouldn’t depend on an inheritance to pay for my medical bills. But for traveling the world — sure.

Flexibility matters when dealing with uncertain incomes. If your financial goal is flexible, it is the perfect candidate for matching to an inheritance. For example, if at my current savings rate, I can retire at 55, and I plan to apply any inheritance towards my retirement nest-egg, and according to my estimate it will hasten my retirement to 50 — great! This goal is flexible enough that I can live well even in the worst case scenario.

5. How does it factor into your net-worth?

In short, the answer is that it doesn't. Really. As far as the number you have, inheritance ought not to be counted, to avoid the milkmaid’s folly.

But the form of inheritance — that is certainly something to consider, which is what I think many financial gurus miss out on.

For example, if you know that your parents own thousands of dollars of Apple stock, and you are reasonably certain of inheriting at least some of it, would you go ahead and buy more Apple stock if your ideal portfolio should contain some of it?

Most people wouldn’t. But the gurus would have you buy it — since inheritance is considered something of a windfall akin to a lottery. Except it really isn’t — it isn’t a game of luck or skill, it isn’t a game at all. It is something that all of us can and do estimate with reasonable accuracy. We do sub-consciously factor in these things, and that is the correct way to go about it. Sure, do not depend on it for your daily survival expenses, but it certainly should be a qualitative factor in your portfolio.

If you expect to inherit thousands of dollars of bonds — make your portfolio a bit stock-heavier than you would otherwise. The worst that could happen is that you get a rude shock and have to rebalance your portfolio.

If you expect to inherit a garage full of cars — maybe don’t buy more, or buy a cheaper one for now.

If you expect to inherit real estate, invest in other forms like stocks, currencies, etc. You can always diversify to real estate if the inheritance doesn’t come through.

Inheritance is complicated, but making it invisible can be living in a fool’s paradise. While we need to accept its uncertainty, it is as much a factor in our net-worth as are other lifestyle factors — quantitatively impossible to pin down but qualitatively crucial.