Suddenly Rich? Learn How to Handle a Windfall

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by Advice Chaser
by Advice Chaser

If you’re on social media at all, you’ve probably seen someone pose a thought experiment: What would you do with a million dollars? A hundred million? A billion? For some people, the thought experiment becomes reality when they receive an unexpected windfall. 

However, this good luck can quickly turn bad if you don’t know how to handle it. Studies show 70% of lottery winners spend all their winnings in five years or less. That certainly isn’t the dream most people have about how they’d spend a fortune.

Windfalls can be small or large and can come from a variety of sources. Maybe you won the lottery or discovered a wealthy great-aunt’s will. But on the other hand, maybe you just got a really nice bonus at work! Regardless of the exact circumstances, there are certain general principles that govern the wise use of financial windfalls. 

lottery balls with numbers on them

Give Yourself Time

Unless you’re in imminent danger of losing your home or something equally dire, try to give yourself time to figure out what to do with your windfall. In some cases, you can receive an annuity rather than a lump sum, so there’s no temptation to blow it all on a whim. In other cases, you can still press pause on any major decisions by putting the money into a high-yield savings or money market account

Be careful who you tell about your sudden good fortune. We’ve all heard stories of opportunistic “friends” and relatives who only look out for their own interests in such a situation. But don’t forget that you could also make yourself a target for scammers if you broadcast the fact that you have a lot of money to spend. 

If you have a large windfall, one of the first and best uses for the money will be hiring a qualified financial advisor. (Make sure to check their credentials!) They can give you a less emotional perspective on your financial situation so you can make your money go as far as possible.

Don’t Forget Taxes

Unfortunately, Uncle Sam is one of the unscrupulous relatives who will definitely want a cut of your windfall—and you can’t avoid paying him! In many cases, a windfall will be taxed according to the more aggressive capital gains rate rather than the income tax rate. Even if it’s taxed as income, having a sudden spike could push you into a higher bracket. However, there are ways to reduce this tax burden, even if you can’t eliminate it entirely. 

If you’re able to get the windfall as an annuity rather than a lump sum, this can reduce the tax burden. This way, you keep your annual income in a lower tax bracket each year. Another option is to offset capital gains with annual losses. 

Also consider contributing as much as you can to your retirement accounts. Since traditional 401(k)s and IRAs defer taxes until you’re in retirement, you can pay taxes later, when you may be in a lower tax bracket than you are now.

If you’ve maxed out your own retirement accounts, you might consider helping your children or grandchildren. A 529 college savings account has tax advantages. You can also consider setting up a custodial IRA. 

Another way to reduce the tax burden from a windfall is to make charitable donations. While it might not have the same appeal as buying yourself a new car or a fancy vacation, you can get the satisfaction of helping the less fortunate instead of simply paying a huge chunk of taxes.

If you have a very large windfall, you can even consider setting up a donor-advised fund. The tax advantages are immediate but you can take your time deciding how to spread your generosity around.

How to Use a Windfall

Once you’ve planned for taxes and charitable donations, hopefully you still have some money left.

Many experts recommend setting aside a small portion of your windfall—perhaps 5 or 10 percent—as fun money. If this seems wasteful, consider whether allowing yourself some indulgences within predetermined limits will help prevent impulse spending down the road. 

Next, consider paying down debt. If you have a lot of high-interest debt, this can be a great way to free up your future income for investments and improving your standard of living. However, paying off debt is only going to be helpful to your future self if you make sure to examine your habits in the process. If you’ve developed the habit of living beyond your means and spending impulsively, an extra cash infusion won’t change that. 

Consider the pros and cons before paying off stable, low-interest debt like your mortgage. While it’s thrilling to be able to say you own your home free and clear, in the long run you could easily be better off investing the money and paying off your mortgage the slow and steady way. One exception to this general rule: If your mortgage has poor terms—perhaps you didn’t have enough money for much of a down payment—consider refinancing to get better terms. 

Finally, consider whether a large windfall will allow you to change careers, go back to school, or start a small business. You definitely shouldn’t turn in your two weeks notice as soon as you scratch off a winning lottery ticket, however. Make sure to look at the long term costs and risks of any major life changes so that you can transition as safely as possible instead of finding yourself broke and unemployed in a few years. 

Get Expert Advice on Managing Windfalls

Far too many people who receive windfalls find themselves no better off a few years down the line. The biggest factor in avoiding this fate is getting expert advice on how to make your good fortune last. Contact us today to connect with an advisor who can help you with whatever comes your way. 

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