Inheriting a large sum during your 40s and 50s could give you the financial freedom you’ve been dreaming of - or give you the chance to build a lasting legacy for your children.

While the best way to use your inheritance will vary depending on your specific circumstances, there are some key areas to consider as a starting point.

Most financial planners recommend holding three months of your average household income in cash

Pay off credit cards and high interest lending

Getting rid of any lingering debt is usually a good place to start, as typically the higher rate of interest paid on store cards, overdrafts and personal loans can prove a big drain on your personal income. You’ll save a significant amount in interest over time, and that left-over personal income can instead be used towards building up your savings and investments.

Build up an emergency fund

Once you’ve managed to clear any outstanding debts, you should consider setting aside some cash as an emergency fund. Most financial planners recommend holding three months of your average household income in cash. This should be enough to help cover any unexpected changes to your income, such as losing your job or emergency home or vehicle repairs.

Of course, the amount you set aside may depend on your regular financial outgoings or nature of your work. But as the pandemic demonstrated, having an emergency fund can make all the difference when something unexpected happens.

Pay off your mortgage

Homeowners often dream about paying off their mortgage early, and an inherited lump sum could turn this dream into a reality. Paying off mortgage debt early could potentially save you thousands of pounds in interest.

However, mortgage lenders usually charge early repayment fees – especially if you have a fixed rate or discounted mortgage. Be sure to check the terms of the mortgage to see whether any charges you pay may actually end up costing you more in the long run.

You should also talk to your financial planner before opting to pay off your mortgage. It might be more tax-efficient to keep your mortgage as it is and use some of your inheritance to make pension contributions instead.

Tax benefits mean pensions are often an attractive way to invest lump sums for your future

Invest more into your pension

Speaking of pensions, they remain one of the most tax-efficient ways to prepare for the future. Basic rate taxpayers who make pension contributions get 20% tax relief (effectively a top-up from the government) on the amounts they contribute. Higher-rate taxpayers can claim 40% relief, while additional-rate taxpayers can claim 45% pension tax relief.

These tax benefits mean pensions are often an attractive way to invest lump sums. And for most people, although the pension annual allowance is now £60,000 (tax year 2023/24) – or 100% of your salary, whichever is lower – you can carry over any unused pension allowance from the previous three years.

So, if you have a lump sum available, you could potentially invest up to £180,000 in tax year 2023/24 (depending on your circumstances) straight into your pension and still claim tax relief on it. This figure is based on the previous annual allowance limit of £40,000 per year, and the assumption that you haven’t made any contributions in recent years. This could make a huge difference to your overall pension pot by the time you reach retirement age.

Make the most of your tax-free ISA allowances...

A Stocks & Shares Individual Savings Account (ISA) lets you invest directly in company shares or bonds, or you can invest in a fund that does the buying and selling on your behalf. Everyone over the age of 18 currently has an annual ISA allowance of £20,000, and any capital gains from your investment are free from tax. Do remember that investment returns are not guaranteed, and you may not get back the full amount you invest.

…and consider broadening your investment portfolio

After you’ve used up all of your annual ISA allowance, you might want to consider broadening your investment horizons and increasing the diversity of your portfolio.

Many people start with a General Investment Account (GIA). Although a GIA doesn’t have the same tax benefits as an ISA, there’s no limit to the amount you can invest, and no time restrictions on when you can put money in, or take it out.

Other tax-efficient investments include Venture Capital Trusts, the Enterprise Investment Scheme (EIS), and the Seed EIS, which give you the opportunity to invest in early-stage, fast-growing businesses. Compared to pensions and ISAs these are much higher-risk investments, as you could potentially lose the whole investment amount.

To compensate investors for the higher risk, they offer several tax incentives, including income tax relief and tax-free capital gains if held for a certain amount of time.

It is important to recognise that investments like these are generally suited to more experienced and adventurous investors, who have sufficient income to benefit from the tax relief available.

Everyone has an annual gifting allowance of £3,000, which is called the ‘annual exemption’

Passing your inheritance directly to your children (or others)

If you’ve been the beneficiary of a recent inheritance, you may want to pass some of it on – possibly to your children. To do this tax-efficiently, you’ll need a document called a ‘Deed of variation’.

Deeds of variation are often used when changes need to be made to a person’s will after they’ve died. A beneficiary can use a deed of variation to alter the inheritance they’ve received, perhaps to share it with others, effectively reducing the inheritance tax liability on their own estate.

A deed of variation should be completed within two years of the death. However, even where the estate has already been distributed to a beneficiary, they can still vary the will and pass the money on to their chosen beneficiary within the two-year period.

Using up your gifting allowances

One of the most popular ways to reduce a potential inheritance tax bill is to ‘gift’ the money away to friends and family during your lifetime. One of the benefits of this approach is that you get to see the money being enjoyed. However, there are rules around how much you can gift to others.

Everyone has an annual gifting allowance of £3,000, which is called the ‘annual exemption’. Gifts up to this amount will not form part of your taxable estate, meaning there’s no inheritance tax to pay on it. If you didn’t use your annual exemption last year, you can carry it over to the current year, meaning you can gift up to £6,000, but only for one year.

You can make smaller gifts of up to £250 to whoever you wish, provided you haven’t given them a gift as part of your £3,000 annual exemption. You can also make inheritance tax-free wedding gifts of up to £5,000 for your child, £2,500 for your grandchild or great-grandchild, and up to £1,000 for anyone else. Any gifts made between spouses or civil partners are completely free from inheritance tax.

Gifts of larger amounts (above £3,000) could trigger an inheritance tax bill. HMRC calls these larger gifts ‘potentially exempt transfers’ (PET). A PET will fall outside of your estate provided you live for at least seven years from when the gift was made. If you live for between three to seven years after making the gift, the inheritance tax amount due will be determined on a sliding scale.

Go on… live a little

For most people, life in your 40s and 50s is all about responsibility. Yet while there are likely to be lots of things you feel duty-bound to spend your inheritance on, it’s important to enjoy yourself too. Whoever left you the inheritance will probably have wanted you to spend at least some of it on the things you love doing.

Amber River offers independent financial advice

At Amber River, our independent financial planners help people of all ages secure their financial future (and that of their families) while making sure they enjoy the here and now too. We call this Life Landscaping® because each individual journey is unique.

Get in touch

To speak to one of our team, arrange an appointment or find out more, call 0800 915 0000, or alternatively use our contact form here.