A financial windfall can be a mixed blessing. On the one hand, who doesn’t welcome additional money? Those funds could come from winning the lottery, inheritance, gift, tax refund, sale of assets, work bonus, or damages from a lawsuit. On the other hand, the money means making decisions about what to do with it. What makes this especially difficult is that there are no absolute right or wrong answers about these matters. Sure, there are general guidelines. But those may not be the best fit for a person’s specific financial situation. Yet, choices will have to be made.
Where there is no choice is attending to any tax liabilities associated with the windfall. Also, fees may have to be paid, as with a commission to the real estate agent or the plaintiff lawyer who won or settled the litigation. What’s left over becomes the balance. Here are the standard options for dealing with it.
Reserve fund. A survey by MetLife found that 50% of those interviewed had less than a month’s living expenses socked away. The Great Recession and acts of nature like Hurricane Sandy taught us that emergencies happen more often than one tends to anticipate. How much of a reserve is recommended? About six months is the rule of thumb. The amount should be enough to cover mortgage/rent, heat/electricity, food, and minimum payments on debt. However, that is not cast in stone. Workers, such as laid-off plumbers, whose skill is in demand, would probably need less since they wouldn’t be jobless for long. Those, such as lawyers, whose industry is downsizing, would need more.
Debt re-payment. Obviously, those debts with the highest interest rates should be paid off first and, if possible, in full. There could be wiggle room if debtors are “buying time” through transferring high-interest credit card balances to zero- or low-interest accounts. If that’s possible, then the question arises if it’s financially smarter to keep stalling as long as possible paying off the balance and invest the money in a CD or a down payment for a house.
Most personal finance advisors tend to be conservative. They’d opt for getting rid of debt. To begin with, it has a negative impact on the FICO or credit score. That, in turn, can affect myriad kinds of financial transactions. For instance, a low FICO score could raise the interest rate on a home loan. In addition, there’s no guarantee that attractive credit card balance transfer offers will be available when the last one expires. That could saddle the debtor with, say, a $24,000 balance at a double-digit interest rate.
With so many financial vehicles available, where to put savings demands research. It’s a mistake to deposit the money in a checking account that yields no interest. Since it loses value because of inflation, it’s comparable to sticking money under the mattress. One option is some kind of savings account. Some financial institutions impose a fee for even a plain-vanilla savings account. That’s one issue to look into. The other is the rate of interest. Is it higher than the rate of inflation? Another option, if the money isn’t needed immediately, is to consider a Certificate of Deposit. The terms and conditions for those, as to interest rate and time the money is tied up, are varied. Therefore, shopping around is necessary.
Those who already have investment accounts, both individual and through employers, can increase their contribution. If they don’t have them, they can start one or more. Often, a windfall gives those employed the financial “breathing space” to finally participate in an employer-sponsored retirement account. Employers sometimes contribute to those.
In all investing, there is risk. That’s the rub. Here the decisions involve how much risk to take. That usually depends on a person’s tolerance for risk, age, other financial assets, and yield objectives. The prudent approach is to interview a number of investment counselors. Chemistry and ability to trust are key. Fee structure is another consideration. Also, it can be useful to request references to speak with. Questions should range from concerns about integrity to financial outcomes, both gains and losses. Until any investment choices are made, the funds can sit in an interest-bearing savings account.
As lottery winners soon realize, windfalls can create a new kind of stress. It takes clear, methodical financial thinking to navigate through all the opportunities to use the funds to improve one’s financial security. You’ll need to pay taxes and any associated fees right away, but other than that, there isn’t any reason to rush into doing anything.