What’s the best thing to do with an inherited IRA?

Dear Liz: I just inherited about $70,000 in IRAs and checking accounts. I would like to eventually invest it in my next home (upgrade to a bigger home) but want to wait a little until I feel more certain about my job. What is the best thing to do with this money in the interim? Certificates of deposit? Money market?

Answer: If you expect to use the money within a few years, you’ll want to keep it safe and accessible. These days, that usually means in an FDIC-insured savings account, since yields on money market funds are pretty miserable.

You’ll typically find the best rates at online banks or your local credit union. You also can consider boosting your yields a bit by laddering some CDs. That just means breaking your money into chunks and investing those chunks in CDs with different maturities. If you arrange your ladder so that some money comes due every three months or so, you can take advantage of rising rates while protecting the bulk of your cash from falling rates. Just make sure that your money isn’t locked up past the point when you’re likely to need it.

But you may want to reconsider your goal for this money. Unless the retirement money you inherited was in a Roth IRA, you will pay income taxes on your withdrawals. You may be better off in the long run by delaying those taxes as much as possible.

That would require putting the IRA money into a new account, called an Inherited IRA, that you open for this purpose. You would be required to take minimum distributions each year, but those would be based on your life expectancy. The bulk of your inheritance would be left alone to grow tax-deferred for many, many years.

Another option, if the original account owner died before age 70 1/2, is to use the five-year rule. That basically means you could leave the money in the Inherited IRA for up to five years. You could withdraw any amount at any time and pay taxes on it, but you must withdraw everything within five years. That would give you the benefit of at least some tax deferral.

Either way, you would need to establish the Inherited IRA by Dec. 31 of the year after the original IRA owner’s death.

What to do with an extra $5,000 a month

Dear Liz: My wife and I are about to sell our home and move in with her parents. We’ll have to drain our savings of $15,000 to pay off the rest of what we owe on the mortgage. After the sale, however, our reduced expenses mean we’ll have at least an extra $5,000 a month. We’re carrying roughly $20,000 in credit card debt and make $130,000 a year in income. I see this mortgage-free living as a great opportunity and don’t want to waste it. Can you recommend a good book or point us in a direction to ensure we capitalize on this interesting time in our lives?

Answer: That must have been one massive mortgage you were carrying. You may feel positively giddy once those payments are gone, but don’t let it go to your head.

It would be easy to ratchet up your spending now that there’s so much extra money in the bank, but resist the urge. Concentrate first on wiping out your credit card debt, then focus on building up your emergency savings. The discipline of paying off debt and building savings will help you learn to live within your means—something you obviously weren’t doing when you took on that home loan and built up credit card debt.

You also should be saving aggressively for retirement, if you aren’t already. Take advantage of any workplace retirement plans, contributing at least enough to get the full company match, and consider funding Roth IRAs for both of you. Roth contributions aren’t tax deductible but the money is tax-free in retirement, and you can contribute up to $5,000 each as long as your modified adjusted gross income as a married couple filing jointly is under $167,000.

You can learn more about the basics by reading Eric Tyson’s excellent primer, “Personal Finance for Dummies.”

How to prioritize your savings

Dear Liz: I put 10% of my income into my 401(k) retirement account and my employer matches up to 6%. Should I also be saving another 10% in a regular savings account? I have $2,500 in regular savings right now.

Answer: You don’t say how old you are, how much you’ve saved for retirement already or what your other debts are. All those factors help determine where your savings should go.

You’re smart to be contributing to a 401(k) and getting the full company match. You can use an online retirement calculator, like the one at ChooseToSave.org, to see if you’re saving enough. If you’re not, you can boost your contributions.

If you’re on track for retirement, the next step is to pay off any toxic debt such as credit cards. (Toxic debt is any debt that carries high or variable rates and that erodes, rather than enhances, your wealth.) Once that’s paid off, you can focus on building up your emergency fund. In general, it’s smart to have at least three months’ worth of expenses in a savings account to be tapped in case of real emergency, such as a job loss.

Should a retiree tap into a 401(k) to pay debt?

Dear Liz: You responded to the question “Should I take $50,000 from my 401(k) to pay off the debt?” with a resounding no. However, part of the rationale was how much the money could grow if it were left alone. That makes sense for a young person, but how would you answer the same question for someone retired at age 66?

Answer: At that age, you wouldn’t face tax penalties for early withdrawal and you’re probably giving up less in future gains than someone who is younger.

But dipping into a 401(k) to pay unsecured debts may still be a bad move if there is any chance you’ll wind up in Bankruptcy Court, because retirement funds are protected from creditors. It’s also unwise if you would be withdrawing a large part of your nest egg, because this money has to last you the rest of your life.

A visit with a fee-only planner can help you decide whether using your retirement money this way makes sense. You can get referrals from www.garrettplanningnetwork.com or www.napfa.org.

Protecting retirement funds: unethical or smart?

Dear Liz: In your column in our Sunday paper, you gave advice with which I strongly disagree. The question to you was whether to pay off a $50,000 credit card debt from retirement funds of $250,000. I found your advice not to use this money, citing tax penalties, loss of retirement income, etc., to be irresponsible. Do you consider encouraging bankruptcy to be ethical financial advice? Once again, another unwise borrower does not have to be accountable and is shown the easy way out. Many people have had to tap their 401(k)s before retirement for various reasons. The money is owed, the borrower has the means to pay it, so he should pay it.

Answer: Why do you think premature withdrawals from retirement funds are so heavily penalized? And why do you suppose retirement funds are protected from creditors in Bankruptcy Court?

It’s because lawmakers have decided that there are some things worse than reneging on your debts, and one of them is an impoverished old age.

Yes, if you take on a debt, you should do your utmost to pay it back out of your current income. If you need to sell otherwise-unprotected assets to do so, then do so.

But tapping retirement funds prematurely is rarely smart, and it’s particularly unwise if there’s a possibility that you’ll wind up in Bankruptcy Court. Advising people of that fact is a long way from encouraging them to file for bankruptcy.

By the way, few people who have been through it would call bankruptcy an “easy way out.” Many people struggle with the decision, put off filing for too long and drain the very resources that could have been protected, only to end up having to throw in the towel anyway.