How to Manage a Windfall

How to Manage a Windfall article image.

Coming into an unexpected sum of money—through an inheritance, a lottery prize, casino winnings or other windfall—sounds like a dream come true, but the experience can prove more stressful than you might imagine. If you're not careful, its benefits could be all too fleeting, and you could even end up with unexpected tax bills. Here are some suggestions for making the most of a windfall.

A Windfall Is Often Considered Income

Many inheritances and all prizes and winnings are considered income, which means you'll have to pay federal income taxes on them and, if applicable, state or local income tax as well. Lottery winnings and game show prizes typically have a flat percentage withheld (24% is common) and paid to the IRS on your behalf, but that may or may not be enough to cover your obligation, depending on your base income level and tax bracket.

If your windfall comes through inheritance, estate taxes and taxes on capital gains (if you inherit and then sell property or stocks) could also apply. Before you start planning where you'll put your funds, make sure there's enough set aside for the tax man.

Consider Consulting an Expert

Potential tax issues, the fact that inheritances typically coincide with the loss of a loved one, and the glare of celebrity that can accompany large lottery wins and game show prizes all can complicate your decision-making. It may be both prudent and comforting to enlist a financial planner to help guide you through your options for getting the most out of your windfall (and potentially avoiding unnecessary taxes on it).

A financial planner can help you review your financial situation and clarify your goals for using your new funds, advise you on obtaining adequate levels of insurance coverage, and steer you toward investments suited to your temperament and needs.

How to Prioritize the Use of Your Newfound Cash

You don't need to dedicate all of your windfall to a single purpose, but before you commit any of it to a particular use, think through your financial situation and options, and identify where the money can do you the most good.

Potential targets for funds include the following, in suggested order of consideration. Note that all may not apply to you.

Pay Off High-Interest Debt

Outstanding balances on credit card accounts or other high-interest loans cost you money every day. Depending on your balance amounts and the applicable interest rates (which exceed 20% APR on many credit cards), paying them down can stem losses of hundreds or even thousands of dollars. An added bonus: Reducing your credit card balances also promotes credit score improvement.

Establish or Add to an Emergency Fund

Experts have historically recommended maintaining a cash account, separate from your primary checking and savings accounts, with enough funds to cover three to six months' worth of household expenses in case of income loss or other unforeseen problems. At the onset of the COVID-19 pandemic, in anticipation of greater economic uncertainty, some experts advised expanding that to six to nine months of expenses. If your windfall allows, increasing your emergency fund (or setting one up if you don't have one) could be a life-saver.

Fully Fund Your Retirement Accounts

If your windfall permits it, and you have an employer-sponsored retirement fund that you aren't funding to the maximum extent allowed by law—for 401(k) and 403(b) plans, that's $19,500 per year if you're under age 50, and $26,000 if you're 50 or older—consider diverting a greater portion of your paycheck into the retirement fund to maximize your annual contribution. Doing so not only boosts your retirement nest egg but, because you can deduct funds saved in 401(k) and 403(b) plans from your taxable income, it can also offset tax exposure from the windfall. If you save for retirement in a traditional or Roth IRA, you can contribute $6,000 per year if you're under age 50, and $7,000 if you're 50 or older.

Invest Prudently

A great way to extend the benefits of a windfall is to put your newfound money to work, building wealth through investments. The type of investments best for you depend on a host of variables, including how much money you have to work with, how much risk you're willing to take on (as all investments carry some risk), and whether you're looking for your funds to grow over time, to provide a near-term income stream, or some combination of both. Among your innumerable investment options are purchasing stocks, bonds and other securities or, if you have sufficient funds, securing rental property or other real estate, or even starting a small business.

If you don't have an employer-sponsored retirement account, or if your existing payroll-funded account is already fully funded, one vehicle for investing in stocks and other securities is an individual retirement account (IRA). A Roth IRA, one of several IRA types, is a popular tool for investing in securities, and you can set up accounts for yourself, your spouse and even your children.

Unlike employer-sponsored retirement plans, use of Roth IRAs is off-limits to individuals with incomes that exceed certain thresholds Individual modified adjusted gross income (MAGI—a calculated amount that's typically close to the adjusted gross income reported on federal income tax returns) must be under $139,000 for the 2020 tax year and under $140,000 for 2021. For couples filing jointly, MAGI cannot exceed $206,000 for the 2020 tax year or $208,000 for 2021.

Unless you're experienced or extremely comfortable with investing, it's wise to consult a financial planning professional or an attorney familiar with your area of interest—securities, real estate, business startups, franchise operations and the like. Sound advice upfront can help ensure you make the right choice for you, and that your dream investment doesn't become a nightmare.

Consider Your Legacy

If the amount of money you receive is sufficiently large that you expect to pass some of it on at the end of your life, working with estate-planning professionals can be extremely valuable. Updating your will, establishing one or more living trusts, and arranging bequests to charitable organizations are some of many options you can explore.

Treat Yourself—in Moderation

While it's probably best to suppress the initial urge to splurge that can follow a surprise cash infusion, once you've taken a breath and considered your options, it's fine to put some expenditures on your to-do list. Sensible spending should probably take priority, such as overdue home repairs or replacement of an outdated car. But if you've got your necessities well covered, there's nothing wrong with booking a vacation or treating yourself to a purchase you've been eyeing.

Beware These "Investments"

There's no such thing as a sure-fire investment, but there are a few "opportunities" that carry extraordinarily high risk. Here are some choices to think twice about if you want your windfall to grow and last.

  • Cryptocurrencies: Bitcoin is the one you've probably heard of, but it's among hundreds of digital currencies traded through online exchanges. Many of these offerings claim tremendous increases in value over time, but crypto exchanges can be highly volatile, are more vulnerable than most investment markets to hacking, and have more than their share of scammers. Some players are making big money with cryptocurrencies, but the risks are high. If you want to sample the market, it's probably wise to do so experimentally and with a smaller percentage of your newfound money, and not bank on it as core of a long-term investment strategy.
  • Collectibles: If you want to use spare cash to buy action figures, baseball cards, comic books, LP records or whatever, do it because you love those things—but don't expect pop culture ephemera to be a long-term investment. Even original artwork, antiques, coins, stamps and other "fine" collectibles are subject to large fluctuations over time. You may occasionally strike gold with a bargain purchase or a sale at the height of a bubble, but over the long haul, you'll be lucky if your collectibles hold their value—and your heirs may end up fighting over who has to unload your prized collection.
  • Questionable home improvements: If your kitchen looks like the set of The Brady Bunch, expanding or updating it with modern appliances and a better layout could improve your home life and add value to your house. But other home projects might add little or no value to the house, and some could even work against you (or your heirs) when it's time to sell the property. Amenities such as home theater/gaming rooms with built-in electronics, koi ponds and water features may turn off as many buyers as they attract. If you want your home improvements to increase your home's market value, consult with a real estate professional who can advise you on what's desirable in your market, and what's likely to leave potential buyers cold.

The Bottom Line

If you've received a windfall or expect one in the near future, congratulations on your good fortune. Enjoy the sense of new possibilities, then give some careful thought to how you can get the most of your newfound wealth. Use it wisely, and today's boon can benefit you well into the future.