What to Do if You Receive a REALLY BIG Windfall

December 10, 2003

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

What would you do if you received a really big windfall, an amount significant enough to change your life forever? We're not just talking lottery daydreams. A major cash windfall could come in the form of an inheritance, life insurance payout, legal settlement or the sale of a small business.

Nobody's suggesting you rest your financial future on such an event to the point of forsaking your current strategy of working, saving and investing. This is particularly true for Baby Boomers expecting large inheritances—according to a recent AARP study, they may be disappointed.

It doesn't hurt to be prepared, however, given all the stories of sudden riches causing unexpected headache or heartache. Here's what you should do if you receive a really big windfall.

First things first: taxes

Once you know there's a significant sum coming your way, the FIRST THING you should do is consult with your tax professional regarding the income tax treatment of the money. Importantly, if all or part of your windfall is taxable, the tax due is already spent.

Based on your tax preparer's projections, set aside in a money market fund or bank account enough cash to cover any estimated federal and state income tax liabilities. The taxes may be due and payable from the time of the event until you file your tax returns.

In Taking Your Lumps: Tax-Smart Ways to Receive a Lump Sum, we discussed the general tax treatment of lump-sum payouts. Here are some additional planning strategies for the year in which you receive a large, taxable windfall:

• Charitable giving. Charitable gifts can be particularly effective in a year when a major taxable event significantly boosts your adjusted gross income. Deductibility of gifts to qualified charities is limited to 50% of your adjusted gross income (30% of AGI for long-term assets), with any unused portion eligible for five year carry-over before it expires. Consider a donor-advised fund such as the Schwab Fund for Charitable Giving: You can receive a current deduction in the year your income is temporarily boosted, and then take your time making distributions to the charities of your choice in subsequent years.
• Deferring income and accelerating deductions. Deferring income and/or capital gains, while accelerating deductible expenses where possible and practical, can take on increased significance in a year when your income is taxed at the highest marginal rate. Be sure to consider the potential impact of the alternative minimum tax (AMT).
• Employee stock options. In a year of extraordinarily high income, AMT from an incentive stock option exercise may be less of an issue. That might present a good opportunity to exercise such options, if it makes sense from an investment standpoint. If your windfall allows you to retire early, keep in mind that you'll have a limited time to exercise vested options with your former employer (for more, see Stock Options And Taxes: What You Don't Know Can Cost You).

Cooling off period

If the windfall radically raises your financial net worth—representing a major change in lifestyle—don't make rush decisions with the rest of the money. Just park it in a safe and liquid place, as you would do with any tax set-aside. Then, expect calls from all sorts of people, including bank representatives, financial salespeople, friends, relatives and so on.

It's a good idea to prepare a response, such as, "I already have an advisor" (a minor fib if you don't yet have one—see below). Also, be careful about making immediate gifts to family members and friends without first talking to your tax professional or financial planner. You may be inclined toward generosity, but once you make an irrevocable gift you can't go back and structure it in the most tax-efficient way. Remember, you’re responsible for any gift taxes due, not the lucky beneficiary.

Financial plan overhaul

Everyone should consider a comprehensive, professional review of his or her personal finances. But in the case of a life-changing windfall, it's a must. Even if you've had a financial plan done in the past, such a significant change calls for a redo. Some areas you'll want to consider:

• Taxes
• Net worth structure, which includes the pros and cons of maintaining debt (including mortgage debt)
• Cash flow given your new lifestyle
• Insurance (for example, you may no longer need life insurance for income-replacement purposes, and may want to increase your personal liability insurance)
• Gift and estate planning

Allocation shift

A life-changing windfall will likely warrant significant changes to your investment approach. Depending on your age, goals and previous circumstances, your strategy may shift in one fell swoop from capital accumulation to capital preservation.

So, even if you're a relatively young, aggressive investor, consider how much risk you really need to take, regardless of time horizon and risk tolerance. Why take additional risk if you don't have to?

The investments you choose may change as well. Given a much larger portfolio, a good portion of which will likely be allocated to fixed income, you may prefer individual municipal bonds to bond funds. This might also be the time to consider a separate-account approach, using professional private money managers.

Perspective

Some folks react to sudden wealth by changing their material surroundings as quickly as they can. They quit their jobs, buy a bigger house, replace the family sedan with a luxury model (or two), make lavish gifts and then book the next Mediterranean cruise out of town.

For others, life goes on pretty much as it did before, albeit with an added degree of comfort and security. Such individuals seek to remain productive and continue to enjoy the close ties of family and friends regardless of changes in personal wealth.

What would you do if a really big windfall came your way? Thinking about it involves much more than taxes and financial planning. It should also involve a bit of self-assessment, where you figure out what's truly important in your life. That sort of perspective can be a windfall in itself.