Getting an unexpected inheritance can provide a valuable boost to your finances – but how do you work out what to do with the windfall?

The average inheritance received is around £11,000, according to figures from the Office for National Statistics, but some people get larger, potentially life-changing sums. Often this is money that people haven’t planned on receiving, so it can be tempting to splurge it, but what’s the best course of action?

TO SPLURGE OR SAVE?

The first thing people think of when they picture a lottery win is usually splurging on a holiday, a new house or something fun for the family. While an inheritance is unlikely to be as large as a lottery win, it can be tempting   to see it as bonus money and spend it.

There’s nothing wrong with treating yourself with some of the cash. You could allow yourself to spend a proportion of it on something frivolous or buy something you’ve wanted for ages. Taking out 10% to treat yourself or the family could work well, and by ring-fencing this as ‘fun money’ you’re less likely to gradually spend a big portion of the inheritance.

DEAL WITH THE BORING STUFF

Before you think about investing or saving any of the money it’s worth paying off any high-cost debt. Lots of people dream of paying off their mortgage with a windfall, and that could be a good use for the money, but you need to make sure you pay off pricier debt first.

Check what interest rate you’re paying on your mortgage and then look at any other debt you have and whether it’s costing you more. Think about credit cards, overdrafts, personal loans or store cards you might have and look to pay those off before you tackle the mortgage.

The next step is to check that your emergency cash is sufficiently topped up. Usually it’s good to have between three and six months of your outgoings set aside in easily-accessible cash. 

INVEST FOR THE FUTURE

If you are already debt-free and have enough cash in reserve, and you think you can earn more by investing the money than by paying off the mortgage, then you could look to save the money for the future.

Make sure you have a saving goal before you decide where to invest it, as this will help determine what you invest in and how much risk you’re willing to take.

If you’ve received the windfall when you’re younger getting on the property ladder might be your target. The average first-time buyer deposit is now £50,000, meaning it’s a high hurdle to reach – but even a £10,000 inheritance would be a valuable contribution.

Using a Lifetime ISA is the best idea if you’re certain you want to buy a home, as anyone eligible for this wrapper will get a 25% Government bonus on top of contributions, up to £1,000 a year.

You can only pay in £4,000 a year, meaning that you’d need to put any remaining money into a normal stocks and shares ISA and then move it across over the following tax years.

If you had a £10,000 inheritance – and assuming you don’t make any further contributions and it grows at 5% a year after fees – with the Government bonus you’d end up with almost £20,000 after           10 years.

BOOST YOUR RETIREMENT SAVINGS

Another option is to put some or all of the money into your pension. For younger people this might seem like a crazy idea, as you won’t be able to access it for so long, but the effect of compounding means that money put away very early on will have a long time to grow until retirement. You’ll also be able to invest in more high risk assets.

Using the same £10,000 example and 5% growth, with tax relief it would be worth more than £110,000 after 45 years invested. However, you need to be certain that you won’t need to access the money, so it’s not a decision to take lightly.

Older people who are nearer retirement will be locking the money up for a shorter period. They can still benefit from putting the money in a pension and getting Government tax relief on top. Even if you’re             not earning an income you can still put £2,880 a year into a pension, which will be topped  up to £3,600 after tax relief, so you could drip feed your inheritance in.

If you’re not interested in buying your first home and your retirement seems too far away, you might want to access the money in the shorter-term or save it for something like a new car, a wedding or to gift to family members in the future.

In this case you’re probably better using an ISA, as the money isn’t tied up and you can get easy access to it. What you invest in will depend on how long you are putting the money away for, but you can add in more risk if you’re investing for longer.

GIVE IT AWAY

Some people might want to pass on their good fortune to charity. You also claim tax relief if you do give the money away.

Many people with children will consider passing some of the inheritance straight to them, if they haven’t received money directly from the deceased.

If large sums are involved a tax-efficient way is to do a deed of variation on the will, meaning that you effectively change the will so a portion of your inheritance is redirected to them.

All the beneficiaries will need to agree. This means that you aren’t gifting the money and so it doesn’t have to be counted for inheritance tax purposes should you die within seven years of handing the money over.

MIX IT UP

Another option is to use a mixture of all of these approaches. You could allocate 10% to your fun money pot, put another 20% in your pension, allocate 50% to an ISA for shorter-term spending and perhaps gift the rest of it between charity and family.

The best thing is to have a plan for the money, make sure you don’t just leave it in the bank earning a measly interest rate, and invest it as tax-efficiently as possible.

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