Coping With Unexpected Financial Luck
Financial windfalls can take many forms – inheritance, from a trust, stock options, winning the lottery and, to a lesser extent, government checks. Too often, people spend most or all of the windfall at once , leaving them nothing to show it off. This is why you need a plan.
Why plan matters
Your windfall income won’t last long if you don’t plan how to save 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 for bankruptcy within three to five years than the average American, because when money management is not yet a strong point, improper spending will simply increase to match the amount of money that can be spent.
While your financial position and windfall may vary, financial advisors usually suggest the following elements as part of your spending plan:
Assess your financial goals
First, you will want to determine the net amount of your incidental income and indicate if it is taxable or paid in installments, as this will affect your contingency plans. For example, inheritance of a taxable asset can have complex tax implications “ underpinned ”, and a 401 (k) inheritance will have unique rules about when you should receive the funds. If your windfall income is significant, you can hire a financial planner to help you navigate a plan that minimizes unnecessary taxes.
Once you have a clear estimate of your windfall income, reassess your financial goals (savings for school, early retirement) and prioritize outstanding liabilities such as debt. Again, your financial advisor can help you with this as it can be tricky – you may strategically want to keep some debt (at low interest rates) in order to achieve some of your larger financial goals, such as accumulating retirement savings.
Pay off bad debts such as credit cards or high-interest loans.
Windfall income 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 don’t get anything for paying 16% per annum on your credit card balance, but this monthly payment can be invested in retirement savings, for example, with a 10% return that will increase over time.
Start or replenish the reserve fund
The pandemic is 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 lose your job. It’s usually a good idea to set aside money for expected expenses of three to six months, although if you get a lot of windfall income, you can increase it to twelve months.
Play catch-up with your retirement accounts
According to Fidelity Investments , if you want to retire by age 67, you should plan to save 10 times your income. The best way to do this is through retirement investments ( 401k , Roth IRA , traditional IRA, or Roth 401k ), which will allow you to grow at compound interest over the years. In addition, some accounts allow you to “catch up” and deposit additional funds if you are over 50 or have not used the maximum contribution limits in previous years.
Create a 529 fund for education spending
Like retirement funds, the 529 fund is a long-term investment that grows with compound interest over time, except that it is dedicated to spending on education. Fund money can be withdrawn tax-free and spent on qualified education expenses such as tuition or books. You will get more bang for your buck if you invest in one of these funds early on, so why not use some of your windfall to set up a 529 for your child (or yourself if pursuing a new career is one of your goals)?
Take care of home renovation
Neglecting home renovations can get more costly the longer you put them off. You won’t get any tax deductions for home renovations, but some – like repairing a leaking roof or a faulty HVAC system – are a ticking cost bomb that can be avoided by investing early (home renovations are often is the reason why homeowners take out home equity and personal loans).
You can spend a little
Again, this depends on your financial situation and the amount of your windfall income, but you can also spend money within reasonable limits. A general rule of thumb among financial advisors is to spend 5% of windfall income on anything, as long as you’ve taken care of your debt and invested in your financial goals. If you’re feeling generous, you can also donate tax-free to charity or directly to another person, such as a friend or family member. You can donate up to $ 15,000 per person before you have to pay gift tax .