With news of the massive Mega Millions lottery prize going to a lucky winner in South Carolina last week, it’s a perfect time to discuss how to handle a windfall.
While most of us will never be lottery winners, there are much more common “windfall scenarios” that can have a major impact on your net worth such as inheritance, receiving a life insurance payout, selling a valuable asset like real estate, or cashing in on your employee equity.
Here are some general guidelines for how to deal with a large windfall:
Secure the funds and don’t do anything immediately.
Upon receiving a large and unexpected sum of money, many people’s natural instinct is to act immediately to make purchases, investments, or use the money in other ways. Before you decide what to do with your windfall, park your money somewhere secure and speak with your family members and your financial advisor. Taking your time and working closely with unbiased financial professionals will help you ensure that your money is being used most effectively, and can help support your long-term financial planning objectives and personal goals. That said, sitting in cash for any length of time is inefficient, so work to put a strategy in place within a couple months of the windfall.
Make sure your estate plan is in order.
We recommend that people review their estate plans on a consistent basis, and anytime a significant life event happens. Some windfalls will dramatically change the size and nature of your estate, so it’s important to make sure this change is reflected in your plan. We recommend working with an estate planning attorney to ensure that your affairs are in order, especially if your estate suddenly and significantly changes. If you don’t need the money from your windfall, you might consider disclaiming it so it can pass to your heirs without being subject to estate taxes.
Understand the tax implications and work with a tax professional.
You will likely need to pay taxes on your windfall — but how much depends on the source of the money. If your windfall was from certain sources like an inheritance, gift, or a life insurance payout, you will generally avoid federal income tax (here is additional information on tax reform’s impact on estate taxes). Funds from sources like lottery winnings or receiving a large bonus are generally taxed at your ordinary federal income tax rate. Income from the sale of real estate or a business, for example, will generally be taxed as long-term capital gains. Keep in mind that you may well owe additional state income taxes on your windfall as well depending on the state you live in and the circumstance of your windfall. How you are taxed greatly depends on how you came into the money, and a tax professional can help you tease out what taxes you owe and how much, as well as advise you on the best use of your newfound funds for optimal tax treatment. Ideally, coordinating with both a tax and estate specialist is key, as some estate objectives (like a charitable donation) may impact your tax picture.
Reevaluate your investment portfolio.
Pre-windfall, your portfolio might have been mostly focused on growth to build wealth. However, if your windfall allows you to re-think this approach, you might want to explore an investment strategy that is focused on protecting your wealth. This might mean significantly re-thinking your asset allocation to optimize your portfolio for wealth preservation and minimizing the impact of future taxes.
Once you’ve ticked these basic financial planning boxes, here are some additional possibilities you might consider when starting to think about how to use your windfall money:
- Pay off high-interest debt. Paying off high-interest debt (like credit card debt) is something you should take care of with your windfall money first, before you even think of splurging or making a big purchase. Talk to your financial advisor about how to deal with other kinds of debt like your mortgage or student loans.
- Charitable giving. Share the wealth! Donating to charitable organizations allows you to both make a difference with your windfall money and reap tax benefits. There are several different ways you can give — contact a financial advisor for advice on the best way for you to do so.
- Think about what insurance you might need. You may no longer need life insurance money if your estate is large enough to support your family after a windfall, but you may want to consider other types of insurance such as a personal extra liability or umbrella policy.
- Set up an emergency fund. If you don’t already have one, putting around 3-6 months of living expenses in a high yield savings account is generally advisable.
Once you’ve taken care of how to manage your windfall and taken care of high-priority expenses like high-interest debt — enjoy yourself! Take that vacation you’ve always dreamed of, start the business you’ve always had in the back of your mind, or buy a new car. Having a team of unbiased financial professionals who are fiduciaries for your money will help you deal with the big practicalities up front so you can enjoy the comfort and freedom that a large windfall can often afford.
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