Buzz
A financial windfall can take many forms, such as an inheritance, trust, stock options, winning the lottery, or even government relief checks in some cases. It's common for people to immediately spend a significant portion—or all—of their newfound fortune, leaving little to show for it. It's important to take a step back and approach the situation with careful consideration. I spoke with Mitch Mitchell, an associate counsel at Trust & Will, who shared the essential steps to take when you suddenly come into a large sum of money.
Why Having a Plan is Crucial
Your newfound wealth won't last unless you have a solid plan to preserve it. For example, a third of Americans will deplete an inheritance within two years, leaving them with negative savings. Even lottery winners are more likely to go bankrupt within three to five years than the average person. This is often because, without solid financial management skills, people tend to mismanage their spending when they come into large amounts of money, causing the same issues to escalate with greater sums.
Mitchell emphasizes that having no plan is the worst decision you can make, primarily because it means you haven’t paused to reflect on your goals and values. Without this clarity, you risk taking a positive opportunity and turning it into something burdensome. According to Mitchell, a sudden financial gain should be a source of enjoyment, free from regrets.
Though the specifics of your financial situation and the amount of your unexpected windfall may differ, financial advisors commonly recommend considering the following components in your spending strategy:
Start by evaluating your financial objectives.
Initially, it's essential to determine the net amount of your windfall and whether it’s taxable or distributed in installments, as this will impact your spending strategy. For instance, inheriting a taxable asset can introduce complex tax issues such as 'set up in basis,' while inheriting a 401(k) comes with particular regulations on when you must withdraw funds. If the windfall is significant, it may be wise to seek advice from a financial planner to create a strategy that minimizes unnecessary taxes.
Mitchell outlines three key approaches to manage your lump sum. The first involves celebrating your windfall by setting aside a portion for personal enjoyment. The second is to put the money to work by considering low-risk options, such as a high-yield savings account or a CD. Lastly, the third option is to allocate the remainder for long-term goals, like funding retirement accounts or a 529 plan for your children's education.
Once you’ve gained a clear understanding of your windfall, take the time to reassess and prioritize your financial goals—such as saving for college or planning for early retirement—while considering any outstanding liabilities like debt. This can become quite complex, and a financial advisor can be invaluable in guiding you. In some cases, it may even make sense to strategically maintain some low-interest debt to support larger financial objectives like growing your retirement savings.
Eliminate 'bad' debts, such as credit card balances or high-interest loans.
A windfall can significantly improve your monthly cash flow if used to pay off or reduce your 'bad' debt. The trade-off is clear: Paying 16% annual interest on a credit card balance offers no return, but if that same amount were invested in retirement savings, it could earn a 10% return that compounds over time.
Begin or increase your emergency fund.
The pandemic has shown us the crucial importance of having an emergency fund. A one-time windfall doesn’t eliminate the need for a rainy-day fund to cover unforeseen expenses, especially if you lose your job. It’s generally recommended to set aside three to six months of living expenses, but if you receive a substantial windfall, consider expanding this cushion to cover 12 months.
Catch up on contributions to your retirement accounts.
Fidelity Investments suggests aiming to save 10 times your income by the time you reach 67 to ensure a comfortable retirement. The most effective way to achieve this goal is through retirement investments, such as a 401k, Roth IRA, traditional IRA, or Roth 401k, which can grow with compound interest. Additionally, some accounts offer catch-up contributions for individuals over 50 or for those who have not maximized their contributions in previous years.
Establish a 529 fund for education-related expenses.
Much like retirement funds, a 529 fund is a long-term investment that benefits from compound interest, but it is specifically meant for education costs. Funds can be withdrawn tax-free and used for eligible education expenses like tuition or books. The earlier you invest in a 529 fund, the more you’ll benefit, so consider using part of your windfall to set one up for a child—or even for yourself if pursuing a new educational goal is in your future.
Address necessary home repairs.
Delaying home repairs can lead to higher costs down the line. While most home repairs don’t qualify for tax deductions, certain issues, like a leaking roof or a malfunctioning HVAC system, can quickly escalate into much larger expenses. Addressing these issues early on with a financial boost can save you from facing expensive problems later.
It’s okay to treat yourself a little.
While it’s essential to consider your financial situation and the size of your windfall, it’s also acceptable to indulge a bit—within reason. A general guideline among financial advisors is to allocate 5% of your windfall for personal enjoyment, provided you’ve already managed your debt and contributed to your financial goals. If you’re feeling generous, you could also make charitable contributions or give gifts to others. You can gift up to $15,000 per person without triggering gift taxes.
Build a team of trusted advisors.
Consult with a trusted accountant, financial planner, and lawyer—professionals who specialize in managing large sums of money and guiding those who receive windfalls, such as lottery winners or beneficiaries. These experts will assist in crafting a comprehensive money management plan, setting financial goals, selecting investments, creating trusts, considering charitable contributions, and ensuring your taxes, estate, and assets are properly handled.
A solid recommendation from a trusted friend or family member can be invaluable. However, to properly vet your advisor’s credibility (which is essential), start by checking NAPFA, the National Association of Personal Financial Advisors. For more information, check out our guide on finding a financial advisor you can trust.
Stick to your responsible spending plan.
It’s perfectly fine to treat yourself with some of the windfall to improve your life and add happiness, but it’s important to set a reasonable budget for discretionary spending. For example, consider allocating 10% of the windfall toward things like a dream vacation, home improvements, charitable donations, helping family, or indulging in something fun like a boat. If there’s no urgent need for these funds (like paying off debt), Mitchell recommends consulting a professional to guide you toward the best investment choices.
By following these steps, you can manage your financial windfall responsibly. Educate yourself, work with trusted professionals, eliminate debt, prioritize smart investments and savings, and budget wisely for some personal indulgence. Making thoughtful financial decisions will ensure you use your windfall wisely. For more estate-planning tips, check out Trust & Will’s helpful resources here.
