What to do with Large Windfalls?

September 1, 2020 Author: Tess Downing, MBA, CFP®, Complete View Financial

Complete View Financial

Windfalls can be a saving grace.

If you’re on a salary and have a regular income, figuring out what to do with a windfall isn’t so complicated. Making spending decisions when you have irregular income is another story.

It doesn’t matter how high or low your commission-based income might be. Just the fact that it’s irregular adds complexity. Unless your income is so high that it covers all your needs and wants, the driving thought behind applying an unexpected windfall – wherever it comes from – will likely be “to reduce uncertainty.”

Individuals and families alike can experience some stress or anxiety as a result of an uncertain income. (Both being and having dependents can ramp that up another notch.) For some, life can be a series of pressure buildups and pressure releases as each month’s income goes down and up.

So, what are some of the thoughts you’ll want to consider when windfalls occurs?

Before that, what exactly is a windfall? The Free Dictionary defines it as “A sudden, unexpected piece of good fortune or financial gain.” It could be a $20,000 year-end bonus, a $350,000 commission for closing a sizeable sale, or a $1 million inheritance.

Now, for the thoughts:

Thought #1: First, take a deep breath.

Particularly if windfalls come at a time when irregular income is causing some distress, the chance of making some irrational decisions could be high. Before making any commitment, you might want to take a deep breath and arrange to meet with an uninvolved third party.

Thought #2: Talk to a neutral party about allocation options

The amount of your windfall compared with your regular finances may help you decide if you want to talk to a CPA and a financial planner. If the windfall might materially affect your net worth, it makes sense to reach out to someone who can help you achieve your life goals. And that would be a qualified financial planner.

The first consideration with a planner could be to see if there are any payout options, such as annual payments rather than a lump sum. Not only might this lower the possibility of impulsive spending decisions, but it can also minimize ‘spending creep’ where the new funds lead you to increase your regular spending in keeping with the extra income, even though it’s a one-time event. And spreading out the payout might help smooth out your tax burden.

A second consideration could be to find a safe place to hold the funds as you make carefully thought-out spending and investing decisions.

So, what are some smart spending options? You might consider any of the following:

Prioritize creating or reinforcing an emergency fund. Particularly with the uncertainty caused by Corona this year, you could face unexpected financial challenges. Having money set aside to deal with any hardships can significantly increase your peace of mind. The minimum to target would be 3-6 months of expenses, although the disruptions to the economy and to everyone’s lifestyle might call for even more.

Pay down high-interest debt first. Credit-card debt tends to carry the highest interest rates. Start with a list of all outstanding debt, including balances and interest rates. You have two decision-making methodologies.

The ‘avalanche’ method of debt repayment calls for paying things off in the order of highest interest rate to minimize total interest cost. The ‘snowball’ method has you pay off the smallest balances first for the psychological push you get when a debt can be crossed off your list. You know yourself best; what method is best for you?

Build up your balances in savings for retirement, education or health expenses. With your planner’s input, you might decide to maximize your contributions to traditional IRAs, Roth IRAs or other qualified retirement accounts.

Or you might decide to use some available cash to pay the taxes as you convert some traditional IRAs to Roth IRAs. It will give you more tax-free income once you retire. However, the cost of doing so will be higher this year if the windfall pushed you into a higher tax bracket. In that case, it might be better to hold the cash until a lower-income year when the conversion cost will be lower.

For education for your children, you might want to look into tax-advantaged 529 college savings plans. And for your future health care costs, it might make sense to invest pre-tax dollars into a Health Savings Account, or HSA. The contribution will be deducted from your taxable income, so it will help lower your tax bill.

Try to make extra payments toward the principal of your student loan if you’re still carrying one. By doing that, you’ll save money on interest payments as well as shorten the payout of the loan.

Your planner can tell you if a similar strategy makes sense with your mortgage: should you make extra payments?

Or do you want to invest in your home in a way that either increases its value (and in turn, your equity) or lowers your ongoing monthly costs? (That could be the case with more efficient windows or appliances.)

If the windfall was linked to personal achievement, can you invest in further success? Are there skills you can learn or networking conferences you could attend to increase your chances? That may be a good use of some funds.

You might want to contribute to a favorite charity. Not only is it a feel-good way to celebrate a windfall but, because the standard deduction for charitable contributions has changed, you might want to look into using a different strategy.

Your planner can explain if a donor-advised fund, for example, would allow you to take the tax break for the donation immediately – when your tax bracket is high – and then guide the distribution from the fund to various charities over time.

Thought #3: Look into the tax implications

You might want to work with a tax advisor to determine if your windfall will affect your tax burden. Taxation will vary, depending on whether it’s the result of a bonus or commission, an inheritance or lottery winnings, for example.

If your windfall is taxable income, then your various financial experts can work with you to minimize the impact while maximizing the benefit to you.

One critical consideration will be if the Internal Revenue Service expects you to make quarterly estimated tax payments throughout the year. This process is already complicated for people with erratic or unpredictable income. A windfall simply adds to the complexity, as do state taxes. Involving a tax expert may be well worth the cost since the IRS readily charges penalties for insufficient payments.

Thought #4: Revisit your estate plan

While a financial planner can help with decisions around spending and investment, and a tax advisor can opine on tax implications, one more expert may be useful. If you have your estate plan in place, you likely revisit it every few years – particularly in the case of a ‘life event.’

A windfall, if large enough, can be a life event. After you have addressed the spending, investing and tax issues, addressing the impact on your estate plan will ensure that it still meets your wishes.

Thought #5: Revise your budget

If you don’t allow a windfall to cause spending creep, you will see its most significant impact on your budget in the form of lower monthly debt payments (if that’s part of how you allocated the funds). Payments on credit cards, car loans, student loans and mortgages could be reduced. And that could be a meaningful relief if lower-income months were causing stress.

Thought #6: Spend a little on you

Whatever the source of the windfall, it’s important to recognize yourself, especially if you earned it through personal effort. It’s only human. In fact, one way to help ensure you do the right thing with the rest of your windfall is to honor – and treat – yourself along the way.

Wrapping up

If you’re entirely dependent on current income to meet your everyday needs, you may want your windfall allocations to be shorter-term to lessen the burden during lower-income months. (It’s not easy to accumulate retirement assets under those circumstances.)

But if your needs can be met despite the fluctuations in income, more of your windfalls can be applied to retirement savings and investment.

If the best allocation is not clear to you, you might want to confer with someone who can review your various alternatives – and the implications of those alternatives. If you think Complete View Financial can help with that process – or be the neutral voice as you make your decisions — do call us for an initial consultation.