Congratulations! You've just received a financial windfall. Maybe it's a large bonus, the sale of a business, lottery win, or an inheritance. Whatever the source, a sudden influx of cash can be exciting, but it’s also important to approach it with a clear head and a well-thought-out plan. Assigning a “home” for every dollar is a great way to avoid or minimize the dreaded lifestyle creep that can wreak havoc on future cash flow.
If you find yourself in this enviable position, resist the urge to make impulsive purchases. Consider this a unique opportunity to transform your financial future rather than a chance to load up on luxury items or make purchases with high ongoing costs.
Depending on the size of your windfall and/or your current situation, the first step may be to connect with a competent fiduciary financial advisor. Whether you work with someone or if you believe you can manage this on your own, below are suggestions anyone in this situation should consider.
Taxes
With some windfalls, taxes are not an issue; with others, taxes can be a considerable issue. It is up to you (and your advisor/tax professional) to learn and properly manage the tax impact of your windfall. It is best to have a good understanding of any tax liability before committing any funds.
Take Inventory
It is always good to know where you stand financially, and this is especially true before making any large financial decisions. Do you have too much debt? Are you saving enough to retire at a reasonable age? Are you making sound investment decisions based on your goals? Is your emergency fund an appropriate size? Are there large expenses, such as funding college for your kids, in your future? How can you best minimize lifetime taxes? Is the size of this windfall enough to support you for life? Are there ways this money could be used to help others without jeopardizing your own financial future? Are there estate planning issues that should be considered? Is now the time to start a business?
The answers to these questions will guide what you should do with your newfound wealth. Assuming no significant outlying factors from above, here are areas most people should consider.
In order of importance…
Pay Off or Pay Down Debt
Since debt is the number one roadblock to financial freedom, we are starting here. Start by paying off or paying down any non-mortgage debt you have.
If this influx of cash is enough to wipe out all your consumer debt, congratulations! From this point forward, make a pledge to yourself to never borrow money again other than to purchase a house. If you were making monthly car payments on an auto loan, continue to make those payments into your savings account. When you have enough saved for the next car, just pay cash.
Top Off Your Emergency Fund
This is a terrific opportunity to beef up your emergency fund. Depending on your age and stage in life, it may be prudent to have 3 to 12 months’ worth of living expenses in this account. These funds should be held in a safe savings or money market account with a competitive yield.
Treat Yourself
Target up to 10% of your windfall to have some fun. What is the point of having a lot of money if you cannot enjoy it? This money may be spent on a vacation, new toy, gift, etc. The key here is to keep this “splurge” bucket to a maximum of 10% of your windfall. If your newfound riches are many times your annual income, it may be prudent to limit this to much less than 10%. In some cases, 1% may be enough.
Long-Term Investments
This account(s) should be primarily invested in the stock market. Nothing has shown a better long-term simplicity and risk/return profile to set you up with lifetime income.
Make sure to take advantage of tax-advantaged retirement accounts like IRAs, Roth IRAs, your work 401k (or equivalent), Health Savings Accounts, etc. Strategically filling up these “buckets” is an excellent way to minimize lifetime taxes.
Share Your Blessings
Target 10% of your windfall for charitable giving. This little slice may pay the largest dividends. If you are reading this, you have a lot to be thankful for. Sharing some of your good fortune is more than being generous—it has been found to have significant health benefits. Sometimes in life you need help. Sometimes in life you get to offer help.
Graduate to 100% Debt Free
If after filling the buckets above you have remaining funds, joining the “no debt” club may be a wonderful option to consider. Regardless of your low mortgage rate and the “mathematical” argument for having this debt, it is still money you owe to someone else. I have heard from many people after joining this club that they never realized what a good feeling it is to be 100% debt-free.
Other Things to Keep in Mind
It is only human to have visions of treating yourself to new luxuries when you have newfound wealth. This trap is what leads many to the poor house. Do not rush into any purchases or financial commitments without doing an honest review of where you are and where you want to go.
Two Different Types of Assets
One reason many lucky windfall winners quickly transition to broke is that they splurge on assets that carry ongoing costs rather than appreciating assets that offer a positive future return. For example, if you find yourself with an unexpected $500,000 and decide to purchase a $500,000 vacation house, you need to factor in what it will cost to own that house every year in the future. You may need an extra $20,000 per year for taxes, insurance, and upkeep. Spending the entire windfall on this one luxury could have a significantly negative impact on your future cash flow.
On the other hand, if you put $500,000 toward paying down debt and beefing up your retirement accounts, you will be in a more positive cash flow position going forward and better set for retirement when that day comes.
If You’ve Got it, Don’t Flaunt it
There are many reasons why you should not share details of your windfall with friends or family. A few to keep in mind:
- Economic imbalances between friends and family can be delicate. The best way to avoid anything uncomfortable is to keep personal finances to yourself.
- People who appear rich are at greater risk of being sued.
- People who appear rich are at greater risk of being robbed.
- People who appear rich are at greater risk of being victims of a scam.
- People who appear rich are at greater risk of being targeted by financial salespeople.
- People who appear rich are at greater risk of being approached by long-lost relatives in need of help.
You can significantly increase your financial well-being without fanfare and stay under the radar. Quietly adding to your emergency fund and paying off your debt can bring much more long-term happiness and peace of mind than splurging on status symbols.
Don’t Quit Your Day Job – Yet
Before deciding you’re set for life, get the opinion of a qualified financial planner. They should have the tools and knowledge to do an analysis of your situation and project your income well into the future. You may be surprised at the results.
Making the decision to retire early is also more than a financial decision. Much of our purpose and social life is tied to our careers. Before making this leap, make sure you have a life plan to fill your days with purpose.
Examples
Here are three examples, using Bob and Karen, 48 and 47 years old, with two kids, 16 and 14-years-old.
Annual Income $150,000
Car loan $24,000 at 6% interest (any consumer debt is bad debt)
Mortgage $125,000 at 4.25% interest (not as bad as consumer debt, but still debt)
Emergency Fund $12,000 (this is behind the target of 6 months’ living expenses)
401k balance: $800,000 (this is a good balance based on age and income)
Situation #1: Work bonus of $50,000 after tax
Here is a prudent “spend” for the $50,000
- $5,000 to church or a non-profit organization
- $5,000 toward their next vacation
- $24,000 to pay off the car loan
- $16,000 into the emergency fund
This plan significantly improves their balance sheet and cash flow while including some money for fun.
Here is a bad “spend” for the $50,000:
- $50,000 down on a $75,000 sports car
Unfortunately, some people would consider the car a good idea. The net effect of this purchase is that cash flow is now worse than before because of the additional car payment and insurance. Because a car is a depreciating asset, the value of it will decrease over time, having a negative effect on their balance sheet.
Situation #2: Bob and Karen receive an $800,000 inheritance
Here is a prudent “spend” for the $800,000
- $80,000 to church or charity
- $50,000 into the “future vacations/house remodel” fund
- $24,000 to pay off car loan
- $125,000 to pay off mortgage
- $63,000 into emergency fund – to round up to $75,000
- $25,000 each into their two kids’ 529 college savings plans
- $408,000 into long-term investments
This plan significantly improves their short and long-term financial situation.
Here is a bad “spend” of the $800,000 inheritance.
- $100,000 for brand new cars for both Bob and Karen
- A $700,000 vacation house on a lake
This example may be the first thing to jump into many people’s minds. Just like the bad example in situation #1 above, this route would make their cash flow situation much worse. The new cars would require higher insurance premiums. After the lake house purchase, a new boat (along with a loan) may follow, new furniture would drain their bank account and/or be put on credit, insurance and upkeep would additionally strain cash flow. A Home Equity Loan may follow to pay off the credit cards and help pay for a new roof. Not a good path to financial peace.
Situation #3: Bob and Karen win $10 million in the lottery
Take a deep breath and find a good attorney and fiduciary financial advisor. Don’t tell anyone about your windfall and don’t make any significant financial decisions without a solid plan.
Obviously, every situation is different, and everything above is offered for discussion and consideration. It’s worth mentioning again, when the dollar amount increases, so does the need for outside guidance including financial, tax, and estate planning. Having the appropriate team of qualified professionals (beware of salespeople) in your corner can provide more than peace of mind.
