How to Deal With a Financial Windfall
Financial luck can come in many forms: inheritances, trusts, stock options, lottery winnings and, to a lesser extent, government checks. Very often people spend most or all of their windfall at once , leaving little use for it. It is extremely important to take your time and make informed and smart decisions about what to do next. I spoke with Mitch Mitchell, Associate Counsel at Trust & Will , to find out the key steps to take if you suddenly have a lot of money.
Why a plan matters
Your windfall won’t last long if you don’t plan how to save your money. For example, a third of Americans will lose their inheritance within two years and be left with negative savings. Even lottery winners are more likely to file bankruptcy within three to five years than the average American. The reason is that when money management is not yet a strength, wasted spending will simply increase to match the amount of money that needs to be spent.
According to Mitchell, the worst thing you can do is not have a plan, mainly because you haven’t thought about your goals and values. Otherwise, you have “taken a good thing and turned it into a curse.” Mitchell says windfalls shouldn’t be a source of regret.
While your financial situation and windfall may vary, financial advisors typically suggest the following items as part of your spending plan:
Evaluate your financial goals
First, you need to determine the net amount of your windfall and whether it is taxable or paid in installments, as this will affect your windfall spending plans. For example, inheriting a taxable asset may have complex ” set in basis ” tax consequences, and inheriting a 401(k) will have unique rules regarding when you must receive the funds. If the amount of your windfall is significant, you may want to hire a financial planner to help you develop a plan that will minimize unnecessary taxes.
Mitchell suggests three main ways to split a lump sum. First, you need to celebrate this windfall and set aside a small amount as “fun money.” Secondly, put your money to work. For short-term goals, this means having a high-yield savings account or some low-risk instrument such as a CD or MMA . Third, set aside the remaining money for your long-term goals, such as retirement accounts or 529 plans for your children’s education.
Once you have a clear estimate of your windfall, re-evaluate and prioritize your financial goals (saving for college, early retirement) relative to your outstanding obligations, such as debt. Again, your financial advisor can help you with this, as this can be tricky – you may strategically want to maintain some debt (low interest) to achieve some of your larger financial goals, such as building retirement savings.
Pay off bad debts, such as credit cards or high-interest loans.
A windfall can be an instant boon to your current monthly cash flow if you use it to pay off or pay off your “bad” debt . The opportunity cost is pretty simple: you get nothing for paying 16% annual interest on your credit card balance, but that monthly payment can be invested in retirement savings, say, for a 10% return that compounded over time.
Create or replenish an emergency fund
The pandemic has been an object lesson in why an emergency fund is important, and a one-time windfall won’t stop you from needing a rainy day fund to pay for unexpected expenses, especially if you suddenly become unemployed. It’s generally recommended to save money for three to six months of expected expenses, although if you receive a large windfall, you can extend this to 12 months.
Play catch-up with your retirement accounts.
According to Fidelity Investments , you should plan to save 10 times your income if you want to retire by age 67. The best way to do this is through retirement investments (either a 401k , Roth IRA , traditional IRA , or Roth 401k ) that grow at compound interest over the years. Additionally, some accounts allow you to “catch up” and contribute additional funds if you are over age 50 or have not taken advantage of maximum contribution limits in previous years.
Create a 529 fund for education expenses.
Like pension funds, a 529 fund is a long-term investment that grows compounded over time, except it is designed for educational expenses. Money from the fund can be withdrawn tax-free and used for qualified education expenses, such as tuition or books. You’ll get more bang for your buck if you invest in one of these funds early, so why not use some of your windfall to set up a 529 for your child (or yourself, if starting a new career is one of your goals)?
Take care of home repairs
Neglecting home renovations can end up costing you more the longer you put it off. You won’t get any tax deductions for most home repairs, but some—like fixing a leaky roof or a faulty HVAC system—are cost bombs that can be avoided by investing early.
It’s okay to splurge a little
Again, this depends on your financial situation and the size of your windfall, but you can spend money too – within reason. A general rule of thumb among financial advisors is to spend 5% of your windfall on whatever you want, as long as you’ve taken care of your debt and invested the money in your financial goals. If you’re feeling generous, you can also make tax-deductible donations to charity or give money directly to another person, such as a friend or family member. You can gift up to $15,000 per person before you have to pay gift taxes .
Assemble a team of consultants
Talk to an accountant, financial planner and lawyer. Make sure they are people you trust who have experience managing large sums of money and helping lottery winners and heirs. They will help you create a wealth management strategy, set financial goals, select investments, establish trusts, potentially plan charitable giving, and ensure your taxes, estate, and assets are properly disposed of.
A good recommendation from a trusted friend or family member can go a long way, but if you want to check the credibility of your advisor (and you do), you should start with NAPFA, the National Association of Personal Financial Advisors . What’s more, here’s our guide to finding a financial advisor who won’t scam you .
Stick to your responsible spending plan
Again, allow yourself to spend some of the money improving your life and bringing joy. Just set a reasonable budget for non-essential quality of life expenses. For example, you could set aside 10% for a dream vacation, home renovation, donating to charity, helping family, or even buying something fun like a boat. If you don’t have the ability to use those funds immediately (like paying off debt), Mitchell says that’s where a professional can help you make the right investments.
Following these steps will help you manage your financial windfall responsibly by educating yourself, relying on professionals, eliminating debt, focusing on smart investments and savings, and budgeting wisely for some discretionary expenses. Making informed financial decisions will allow you to effectively manage your windfall. For more advice on all estate planning topics, visit Trust & Will resources here .