So...you’ve found yourself on the receiving end of a large and unexpected infusion of cash.
Maybe it came in the form of a larger-than-expected holiday bonus at work, an inheritance from a recently departed loved one, a lottery jackpot, or something else entirely. Whatever the case, you’ve found yourself in the envious position of having a relatively large sum of cash burning a hole in your pocket.
You might be tempted to use that cash to pay for things you’ve always dreamed you might one day be able to: A new car, home upgrades, trip around the world, etc. But if you can resist the urge to splurge, that windfall can act as a solid foundation upon which you begin to build real and lasting wealth.
Below, we take a look at some smart ways that you can use your windfall.
What is a windfall?
When someone receives a large and unexpected amount of money, it’s commonly referred to as a windfall. Common windfalls include:
A significant inheritance
A larger-than-expected work bonus
An unexpected tax refund
Lottery or casino winnings
The sale of a business
An insurance settlement
Life insurance death benefit
The primary difference between a windfall and regular income is that a windfall is unexpected. While windfalls usually involve a large sum of money, “large” is a relative term. Depending on your personal financial situation, a windfall can be as small as a few hundred dollars to as large as millions of dollars.
What to do when you receive a windfall
Understand how the windfall will be taxed
Before making any plans for your windfall, it’s important to understand how it will be taxed, because different types of windfalls may be subject to different types of state and federal tax. Just because you get $100,000 doesn’t mean that you’ll get to keep all of it.
If you receive an inheritance, for example, you may need to pay a state inheritance tax, depending on where you live, how much you inherit, and your relationship to the deceased. If you receive a work bonus, however, it’ll be treated as supplemental income by the IRS and taxed as such. It’ll also be subject to state income taxes, as well as Social Security and Medicare taxes. If you receive a life insurance death benefit, it typically won’t be taxable.
It can be a good idea to speak with a tax professional once you become aware of the fact that you’re going to receive a windfall, as there may be ways to lower your tax burden.
Prioritize your financial goals and how you want to spend your windfall
Once you know how much of your windfall is yours to keep, you can begin planning how you’ll spend it. This is the fun part. Depending on the size of your windfall, some of the things you thought you may never be able to afford to do could be in reach. The key, before you spend any of the money is to prioritize what’s important to you. Taking the time to stop and think about how you really want the money can help make sure you don’t just go blow it all on things that aren’t important. On the flip side, it can also free you to spend it on the things that do matter.
Some common financial goals include:
Paying for your child’s college education
These are just some common goals. Ultimately, the money is yours to spend as you’d like. And it’s ok to spend some of it on yourself now. But it can also be an opportunity to improve your financial situation now and in the future. Here are a few ways to use a windfall to improve your financial picture.
Ways to put your windfall to work now
Build emergency savings. For most people, an emergency fund is the foundation upon which their entire financial plan rests. Few things offer the same peace of mind that comes from knowing that you have money set aside and accessible in the event of an emergency or unplanned period of unemployment.
How much money you save in your emergency fund will depend on a number of factors. That being said, a target of six months’ worth of expenses is a great starting point for most people.
If you already have an emergency fund, it can be a good to revisit it and make sure it still meets your needs. Your expenses can change significantly as your life evolves, and your emergency fund needs to adapt alongside it.
Pay down high-interest debt. If you have any high-interest debt (think: 10 percent or greater) using your windfall to pay them off ahead of schedule can lift the weight off your shoulder, and save you a lot on interest payments. Credit cards and other forms of bad debt will typically fall under the umbrella of “high interest” debt.
Does this mean you should use your windfall to pay off all of your debts? Probably not. While you may not like carrying debt, paying off lower-interest loans ahead of schedule means that you aren’t putting your money to work in other ways that might yield a higher return. Additionally, some types of debt (like a mortgage) come with tax benefits —which you’ll be forfeiting by paying off the debt ahead of schedule.
Ways to put your windfall to work for the future
Open an investment account. If your financial goals require a significant amount of money, investing some or all of your windfall can go a long way in supercharging your progress toward those goals.
If you’re new to investing, here’s some quick advice to help guide you as you get started:
The sooner you put your money to work, the better. The more time your money spends invested in the market, the more it will be able to compound and grow.
Diversification is likely the way to go. When you diversify your investments, you spread out your risk and reduce the likelihood that you will experience a total loss of principal. It’s one of the most-repeated pieces of investment advice for a simple reason: It works. The good news is that you don’t have to pick all the investments yourself. Mutual funds or other funds like exchange-traded funds allow you to invest in a basket of investments and provide diversification.
Consult with a financial advisor
Perhaps the best news is that you don’t have to figure it out alone. A financial advisor can help you clarify your financial goals, can help you balance what you want today and in the future, and then can show you financial strategies to help you reach your goals.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Diversification and strategic asset allocation do not assure profit or protect against loss.