Sure, you’ve dreamed of winning the lottery or receiving a huge bonus at work…but what would you do if you really did land upon a large sum of money?
It may be more common than you think—globally, 69% of retirees plan to leave an average inheritance of $148,000 to their children (the average amount is even higher in the U.S., at $177,000). Many even give money to their children before they die: about 35% of working-age Americans have already received an average of $24,000 from a family member.1 When you also account for financial gains from lawsuit settlements, property sales, salary bonuses, and yes, the lottery, figuring out how to wisely manage a significant amount of new money is a challenge many Americans face.
So what’s the secret to being smart about managing a windfall? Below are 10 key steps that can help maximize your newfound money and put you on more secure financial footing.
Lock it up—temporarily.
Tempting as it may be to buy a new car or book a great vacation, put the money into an FDIC-insured, easily accessible account (savings account, money market account, or CD) while you determine the best strategy for your windfall. Sitting on the money for a few months can help clear your head of any desire to spend it away, and it will help give you the time you need to develop a financially sound plan for your money.
Pay Uncle Sam.
You may already be planning how to spend your newfound wealth, but unbeknownst to you, the government may have plans for it as well…because for most sources of a windfall, the government will take a portion of it in taxes. You’re likely to incur federal and/or state income taxes, capital gains taxes, or estate taxes on your money, which can mean up to 39.6% of your windfall may be going to the government. That’s why it’s important to figure out what you’ll need to pay in taxes right when you receive the money (talk to a certified public accountant or tax specialist if need be), and then set it aside so that you don’t run into trouble come tax time. “Consider that money already spent,” says Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research.2
If you have costly, high interest rate consumer debt (like credit card or student loan debt), now is your chance to get rid of it. Paying interest rates on debt is money you’re essentially giving away with no benefit to you; plus, a high amount of credit card debt can have a negative impact on your credit score. That’s why one of the first things you should do with your windfall is to eliminate any consumer debt—especially before you start investing your newfound money elsewhere.
That being said, there are certain kinds of debt that may not be beneficial to pay off in full, as they can carry a tax benefit. Mortgages and some student loans can be deductible from your taxes, and if you’re paying a low interest rate on these loans, as are many people who’ve recently refinanced, you may get a better return by keeping this debt and investing your windfall elsewhere.
Plan for emergencies.
You never know when you might incur a major medical expense, need a new roof on your home, or get laid off…so make sure these types of potentially costly events don’t ruin your finances. If you don’t already have an emergency fund equivalent to six months of expenses set aside, create one now. You’ll be glad you did the next time your car breaks down.
Talk to a financial professional.
While many people have a “do-it-yourself” attitude when it comes to managing their finances, now may be a wise time to consult a financial advisor – even if just for a few sessions. Ask friends or relatives for a trusted recommendation; ideally you might want to look for someone who is a certified financial planner who charges by the hour to avoid the potential conflicts that can be associated with commission-based compensation.
A financial advisor can provide a comprehensive review of your finances, help you modify your financial priorities as needed, and craft a strategy that will help you meet your life goals – whether that means paying for college for your kids or retiring early (or both!). He or she can also help you navigate transferring inherited accounts into your name, as well as avoiding pitfalls with special types of inherited assets, like inherited retirement accounts (which have different rules than other types of inherited money). Additionally, many financial advisors can also help you ensure you’ve got the right insurance coverage, from life insurance to umbrella policies, to make sure you and your loved ones are adequately protected from unforeseen events down the road.
If you’re in your 30s, 40s, or 50s, your investment strategy thus far has probably been to grow your portfolio as much as possible to accumulate wealth. However, now that you’ve come into new money, you may want to reconsider your growth strategy for one that focuses more on portfolio preservation and buffering against potential market downturns. “It makes sense not to take any more risk than you have to,” Rande says. “Once you’ve got it made, you don’t want to lose it.”2
Changing your portfolio’s asset allocation to have a larger focus on fixed income vs. equities will help protect your money against future market volatility. You may also want to consider tax-free investments like municipal bonds,3 which can help reduce future tax payments (especially if you’re now in a higher tax bracket as a result of your windfall).
Give, give, give.
Another great way to decrease your tax liability from your windfall is through charitable giving – and the bonus is you can feel great about who you’re helping in the process! You have many options when it comes to giving – you can give directly to a foundation or charity, or invest through a donor-advised fund (the latter of which provides an immediate tax benefit). Talk to a financial advisor and potentially a CPA or estate planning attorney about the pros and cons of different charitable giving vehicles, as they can help you find the ones that are right for you.
Not saving the maximum annual amount the IRS allows in your 401(k) or IRA? Now’s the time to fund these accounts up to the IRS-allotted limits to help make sure you’ll have enough money for retirement. If you’re over 50 or did not take advantage of the maximum contribution limits in past years, some accounts will even allow you to make “catch up” contributions. If you have pre-college age children, consider investing in 529 plans or other college savings plans to take advantage of tax-deferred growth potential and ease the future burden of college tuition. Qualified distributions from these plans are typically tax-free as well.
Take steps toward your goals.
Now that you’ve set aside money for taxes, paid down debt, and taken care of your long-term planning accounts, take a portion of the remaining proceeds to fund life or career goals. Always wanted to start your own company, teach underprivileged children, or learn interior design so you can remodel your home? Here’s your chance.
Have a little fun.
Finally, treat yourself with some of the money that’s left over. Make a prioritized list of what you’ve always wanted, based on what will bring you and your family the most happiness, and consider investing in some of those items. You only live once, so let the luxury of a windfall help you have some fun while you’re at it.
How Schwab can help:
With a wide variety of investment options and a highly-qualified team of over 350 financial consultants nationwide, Schwab can provide comprehensive investment help and guidance in a personal way that’s right for you. Let us help you maximize your windfall to meet your life goals. Visit us online to learn more or call us at 877-302-5886 to speak with an investment professional today.