Image: Last will and testament © Tetra Images, Getty Images

Receiving an inheritance, especially an unexpected one, might leave you feeling a little overwhelmed by the options. Ideally, the money should bring you closer to financial independence, but many heirs don't know how to handle a windfall and end up no better off than they were before.

The first priority is to develop a strategy. "Most people run through an inheritance in two years or less," says Jason Flurry, the president of Legacy Partners Financial Group in Woodstock, Ga. In his experience, the first mistake people make is they "blow the money on stuff for themselves." The second mistake: choosing bad investments because they consider the inheritance "found money" and, consequently, take on too much risk.

A dollar is still a dollar, whether you or your benefactor earned it. So before rushing out to buy a big-screen television or invest in the latest hot stock, develop a game plan.

Take inventory

Flurry suggests starting with an inventory of your financial life. Take a close look to determine if you have adequate insurance, are on track for retirement and have an emergency fund that will cover you for at least six months or a year. Also identify the amount of high-interest debt you are carrying. "Make sure your foundation issues are in place," he says.

Everyone's financial game plan will look different depending on age, level of debt, whether they are supporting children or parents, and how they want to live in retirement. The point is to gain financial stability in the pressing areas and put the remainder toward reaching your goals. Some of the possibilities include:

  • Paying off high-interest debt, such as credit cards. Whether you pay off a lower-interest mortgage that has some tax deductibility will depend on your personal feelings about carrying a mortgage into retirement and your net worth outside of the value of your home. If you still need to beef up your retirement fund, put the money there first; ditto for an emergency fund.
  • Contributing to a college fund. Those who want to contribute to their children's education can add money to the college fund, but be sure to research how it may impact potential financial aid resources, either from the federal government or from the educational institution.
  • Funding your retirement. If you're close to retirement, focus on income, Flurry says. "Put the money into areas that are reasonably stable as sort of an all-weather approach." Just don't play it so safe that your investments can't keep up with inflation.

There's nothing wrong with buying a luxury item for yourself with some of the money, Flurry says, but the reward will be sweeter if you've figured out your long-range financial plan first.

Don't act rashly

When someone inherits, Flurry says, "The temptation is to feel like you have to do something, but you really don't. Sit down and dream a little, then back into the numbers and ask, 'How can we do this with the least amount of risk?'" Acting too hastily can lead to trouble. Paying off your mortgage without thinking about future income in your old age, for example, could leave you living debt-free but in poverty. "If your house is paid for but you run through everything else, you can't use shingles to pay for groceries," Flurry says. "Then what do you do? You don't want to be in that situation."

If you've inherited a traditional IRA, research the options available before making changes. If you're not a spouse, you can't roll the inherited IRA into your own. Non-spouses are required to take taxable minimum distributions every year based on life expectancy. Instead of treating the distribution as an annual windfall to be spent, make a plan to integrate it into your long-term strategy.

Dial down risk

Constructing a portfolio that generates passive income is the slow-and-steady approach that will lead to financial independence, but it's a step most people miss, according to Flurry.

He says creating a portfolio that throws off a steady stream of income is not as sexy as finding the next big investment, but it's a safer long-term strategy. To achieve stability and income growth, you'll need to mix stocks and fixed-income investments, but don't speculate by sinking it all into volatile equities. "It's kind of a 'get rich slow' plan, but it works," Flurry says. "So many people take unnecessary risks."

On the other hand, depending on your age when you inherit, you might not want to keep the inherited investment portfolio as-is if it is too conservative to provide the necessary growth to get you to your financial goals in 20 years. The point is to make the money work for you without unnecessary risk.

Hire an expert

Consulting a financial planner, investment professional or tax accountant will help you maximize your current plan or help you develop a plan if you don't have one. If you know you'll inherit, you can begin planning ahead of time, but if the inheritance comes as a surprise, a professional can provide a better idea of your options.

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"People will come out of the woodwork," Flurry says. Banks and insurance companies, in particular, may try to sell you a variety of products. "There's nothing wrong with that," he adds, but don't rely on sales representatives. Get an objective opinion that is based on your entire financial picture and a thorough understanding of your goals.

Complicated assets, such as a family business or an asset you've inherited with others such as a home, will probably require a professional to help sort out the options.

Though a master plan will help you keep and grow the assets you've inherited, it doesn't have to be perfect or static. It can and should change over time. "The average plan is better than no plan," says Flurry. "Stick to your goals, and that will provide your true north."

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