Unexpected money is a wonderful thing, whether it's an inheritance, a bonus at work, a lottery prize or a legal settlement.
Problem is, people have a tendency to treat this money differently than hard-earned cash. There's a temptation to splurge: to buy that massive flat-screen TV, take a pricey vacation or make a riskier-than-usual investment. That's fine, to some extent, but only
taking care of the biggest priority: maximizing the effect of the unexpected windfall on your short- and long-term financial health.
Obviously, the right way to handle a windfall varies, depending on your financial situation, the amount of money you've come into and, as Americans have seen in recent months, what's happening with the markets and the economy. But whether you've gained $10,000, $100,000 or even $1 million, the same guidelines typically apply:
Take your time:
Many financial planners and experts suggest stashing the cash in a CD or high-interest savings account, something safe and liquid, in other words, for a while. This accomplishes two things: First, it makes the windfall feel less like "found" money and more a part of your overall financial picture. Second, it gives you enough time to figure out the best way to handle the funds.
Figure Uncle Sam's cut:
Whenever you come into money, tax consequences may follow. This is a crucial consideration, since taxes decrease the size of your windfall. Winnings from gambling, raffles, legal settlements and other windfalls are taxable, for example. And inheritances and life insurance settlements may be subject to estate taxes.
Seek help from a tax professional or a financial planner who's willing to lend tax advice. If you're concerned about how the windfall might affect alimony, child-support obligations or financial-aid packages, a financial planner may be particularly helpful. Remember, too, that a windfall may affect your own estate planning, which is another reason to seek professional advice.
Once you've determined your after-tax windfall, plot out a plan for the money that balances short- and long-term goals.
For most Americans, the best use of "found" money is to pay off debt, especially high-interest debt such as credit cards. Also consider paying off other forms of personal debt. A car loan, for example, pays for a depreciating asset, often at rates of 6% or more.
When it comes to paying down a mortgage or student loan, the decision isn't as clear-cut. Mortgage interest is usually tax-deductible, and student-loan interest can be, too. Still, some folks gain a significant feeling of safety from paying off major debts. If you're one of them, paying off your mortgage or student loan may be wise.
Save, save, save:
Do you have an emergency fund worth three to six months of living expenses? If not, creating one, typically in a high-yield savings account, should be your next priority. This money can protect you against a lost job, illness or other unexpected events, even the need for a new furnace or vehicle.
Then consider these other savings goals:
- Retirement. For most people, saving for retirement is their toughest financial challenge. Max out contributions to tax-advantaged retirement plans. Then consider investing in taxable retirement investments.
- College. As tuition costs skyrocket, funding a child's education is near the top of every parent's list. But remember: Loans are available for college, often at low interest rates. Those loans aren't generally available for retirement costs, so you may want to divert any extra funds to your own savings first.
- Shorter-term goals, such as a down payment on a house. Consider, too, establishing or adding to a savings account for major, optional expenses, such as a big-screen TV or luxurious vacation.
And, yes, spend:
To avoid overspending or compromising larger goals, consider setting aside a specific portion of the windfall as "fun money." Spending on a new house, improvements to a current home, a new car or a family trip, or making a charitable donation can be truly rewarding. Stick to the limit you've set, and enjoy your spending while knowing you've put the highest priorities first.
Mike Woelflein is a business and personal finance freelance writer. A former senior industry specialist with Standard & Poor's and managing editor of ColoradoBiz magazine, he has also written for The Denver Post and American Express.