A reader wants to know how to save an inheritance effectively and minimize the tax liability.
I have a question about what to do with approximately $125k that my dad plans to give me when he sells the family home next month. I am debt-free and renting and I plan to use the money to buy a house but I won’t be ready to do that for another year or so. What should I do with this money in the meantime to make it work for me while still keeping it accessible? What are the tax implications for me? I am trying to plan ahead so that I can make the most of the situation. Thank you so much for your help!
—Kristine P in New Hampshire
Denny Ceizyk, LendingTree Mortgage Expert, responds…
First of all, kudos to you for thinking ahead to plan for your home purchase. You’ll have plenty of time to make adjustments to your finances so you’re ready to buy a home and improve your chances of getting the best rates and terms possible.
Even though you’re not planning to buy for a year, you should get pre-approved for a mortgage. It will help you understand what your credit score is, how much your payment will be based on the price of homes you’re interested in, and whether your current income and debt will allow you to buy the home you want.
Why pre-qualifying is a smart choice
While having so much money for a down payment is definitely a big plus, you still need to meet the credit score and total debt requirements needed to qualify for a mortgage. Your credit score has the most impact on the mortgage interest rate you’ll receive.
Were you to have high balances on your credit cards you might consider paying them off or down, and then keep those balances under 30% of your available credit. For example, if you have $10,000 of available credit, keep your total balances at $3,000 or less. Although 620 is the minimum score required for most home loan programs, a 740 score will help you snag lower rates and offer an easier path to loan approval.
Your debt-to-income ratio is another important factor in mortgage lending. This measures your total debt, including the new house payment by your before-tax income. The Consumer Financial Protection Bureau recommends a DTI ratio of 43% or less. A lower DTI ratio is more important if you have lower credit scores. If your DTI ratio is higher than 43% and you don’t have a lot of credit card debt, consider making bigger payments on student or car loans.
Pay off credit card debt so you can become mortgage-ready.
In your case, you say you’re already debt-free, which is a huge advantage. Just make sure that you stay that way as you get pre-approved and get ready to buy.
Keep those funds liquid
The most important thing to do with your money is to keep it as liquid as possible. Lenders want to know you can convert your money to cash for a down payment without tax penalties, prepayment penalties or borrowing against the money. Checking accounts, savings accounts and Money Markets are examples of liquid accounts. Though interest rates are low, you can opt for a high-interest saving account to earn some money on the investment.
If you put the money in a Certificate of Deposit or retirement account, you won’t be able to access it for a set time or could end up paying a tax penalty for withdrawing the funds. These are considered “semi-liquid” accounts because they aren’t as easy to change into cash.
Roth IRA investment may help you avoid penalties
If you’d like a higher return than you’d get from a savings or checking account, your best bet would be investing in a Roth IRA. Unlike traditional IRAs or 401(k)s, you can withdraw your contributions for a down payment without any tax implications. The interest you earn on the money, however, must stay put until you are 59 and a half to avoid penalties.
That being said, temporarily investing the funds in a Roth or elsewhere does run the risk of losing some or all of your money if there’s a sudden drop due to economic or market conditions. Since you’re thinking of buying in a year or so, you’ll have very little time to make up for any losses.
Deposit the funds immediately
Also, make sure you deposit the down payment funds into an account as soon as possible. Lenders like to see funds that have been in the bank for at least 60 days. Large deposits require explanations and documentation that could become a headache, so if you split up the money into several different accounts, keep statements so the lender can see how the funds are moving from account to account.
Consider keeping a cash cushion of up to six months’ worth of your mortgage payments in the bank as well. Also known as mortgage reserves, some lenders may even require them as a rainy-day fund if you suddenly lose your job or face an unexpected medical expense.
Tax implications apply to the donor more than the recipient
As far as tax implications, that may actually be more of an issue for your dad than you. The IRS gift tax is charged to the donor for any amount over $15,000. There may be arrangements that allow you to pay the gift taxes instead, but it’s best to check with a tax professional to make sure you understand whether or not it’s the best option for you.
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Published by Debt.com, LLC