This may not seem like much of a problem to have but according to the National Endowment for Financial Education, as many as 70% of Americans who will receive a sudden windfall will lose it all within a few years. Even worse, it can cause you to feel richer than you are and develop habits of overspending that can be hard to break once the windfall is gone. Even a seemingly one-time splurge like a luxury car will continue to cost you in higher maintenance and insurance bills long after the initial car purchase. So whether your windfall is from a prize, a tax refund, a bonus, a sale of a home, or an inheritance, here are some things to consider:
Do you have enough emergency savings?
Your first priority should be to have some money set aside in case of an emergency. Start with at least $1k in the bank to cover routine emergencies like car and home repairs. Ideally, you’ll want to build up enough savings to cover necessary expenses like your rent or mortgage, car payment, utility bills, and groceries for at least 3-6 months in case you’re ever in between jobs for that long. To be on the safe side, you may even want enough to cover 6-12 months. This money should be kept somewhere safe and accessible like a bank account or money market fund, not invested in anything risky.
Are you maxing the match in your employer’s retirement plan?
If not, you’re leaving free money on the table and there are not a lot of other places I know where you can get a 50-100% guaranteed return on your money. If your windfall is a bonus, you should be able to increase your retirement plan contributions for that paycheck. If not, you generally can’t write a check from your windfall to your 401(k) but there is a roundabout way of getting the money in there by temporarily increasing your retirement plan contributions and using the windfall to cover the shortfall in your paycheck.
Do you have any high interest debt?
The next priority should be paying off high interest debt like credit cards or payday loans. That’s because if the interest rate is over 6-8%, it’s more than you can reasonably expect to earn by investing that money instead. (You can use this Debt Blaster calculator to see how much interest you can save and how much sooner you can be debt free by putting extra money towards your debt, starting with the highest interest balances.) On the other hand, lower interest debt like mortgages, car loans, and many student loans can be considered good debt because you can typically earn more in the long run by investing the money than you would save in interest by paying those debts off sooner. Of course, there’s also the emotional factor of how you feel about being debt-free vs. having a larger nest egg.
Do you have access to a health savings account?
If you have a qualified high-deductible health insurance plan, this year you can contribute up to $3,250 for a single person or $6,450 for a family plus an additional $1k in either case if you’re over age 55. This money has the double tax benefit of going in pre-tax and coming out tax-free if used for qualified health care expenses. Unlike flexible spending accounts, anything you don’t use can be rolled over for a future year and can eventually be withdrawn after age 65 for any reason without a penalty (otherwise you have to pay taxes plus a 20% penalty for non-qualified withdrawals before age 65). Given the fact that you’re almost certain to have health care costs in retirement, there’s actually a good argument to try to cover your health care costs out-of-pocket and let your health savings account grow tax-free, especially if you’re allowed to invest the account in mutual funds for the long run. After all, you wouldn’t withdraw money early from your retirement accounts if there was no penalty, would you? Speaking of retirement…
Are you on track for retirement?
If you’re not sure, see if your employer or retirement plan provider has a tool like Financial Engines to help you project your retirement income or you can use our simple retirement plan estimator. If you need to save more, we already discussed how you can use a windfall to contribute more to your 401(k). You can also contribute up to $5,500 this year (plus another $1k if you’re over age 50) to a traditional or Roth IRA. The former may be tax-deductible and grows tax-deferred while the latter provides no tax benefit now but grows to be tax-free after age 59 1/2 as long as you’ve had the account open for at least 5 years. They can also be used penalty-free for education expenses or for up to $10k of costs related to a first-time home purchase.
Roth IRAs have an additional little-known benefit in that the sum of your contributions can be withdrawn tax and penalty free anytime for any reason. That means you can actually use it as part of your emergency fund too. If you do that, just be sure to keep the Roth IRA invested somewhere safe like a bank account or money market fund until you have enough emergency savings outside the account. At that point, you can invest the Roth IRA more aggressively for retirement.
If you earn too much income to contribute to a Roth IRA, there’s actually a backdoor way to get around that by simply contributing to a traditional IRA and then converting it into a Roth IRA since there is no income limit on conversions. The only caveat is that if you have other pre-tax IRAs, you’ll have to pay tax on part of the money you convert. However, you can avoid that as well by first rolling those other IRAs into your employer’s retirement plan.
If you’ve maxed out your retirement accounts but still want to save more for retirement, don’t be afraid of investing in a regular brokerage or mutual fund account too. Since you’ll have to pay taxes on these accounts, you’ll want to use them for your most tax-efficient investments like tax-free municipal bonds, individual stocks, and low turnover stock mutual funds. Stocks and stock funds are taxed at lower capital gains rates as long as you hold them for at least 12 months and you can benefit from their higher volatility by taking the inevitable losses off of your taxes. If you never sell them, they can eventually be passed on to your heirs tax-free. International stocks particularly make sense in taxable accounts since you’ll also be eligible to take the foreign tax credit on taxes paid overseas, which you can’t do in a tax-sheltered retirement account.
Finally, buying a home can also be considered part of your retirement plan. After all, having a paid-off home in retirement means not having to pay for housing, which could otherwise be a significant expense. You can also invest in real estate for rental income or free up the equity in your home by downsizing or taking a reverse mortgage. You can learn more about the steps in buying a home here.
Do you have future education expenses?
Only once you’ve gotten all your other ducks in a row should you set money aside for education expenses. After all, there is no financial aid for retirement. But if all your other needs are taken care of, you can save money that grows tax-free for qualified education expenses in 529 or Coverdell Education Saving accounts. 529 accounts also have estate planning benefits in that you can gift up to 5 years’ worth of annual gift-tax exemptions upfront (a total of $70k per person) without having to file a gift tax return. The money comes out of your estate but you can still control how it’s invested and how and for whom it’s used. You can learn more about these accounts at SavingforCollege.com.
Of course, you can always decide to use at least part of the money to treat yourself. Just be sure to weigh the temporary pleasure that this brings with the longer term satisfaction of having more financial peace of mind. Otherwise, your windfall could end up like this.
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