A onetime financial windfall, whether it’s an inheritance, an unexpected bonus, or a hefty tax refund, can set the stage for a lifetime of financial freedom. But it can also inspire some pretty impressive money management mistakes.
Faced with the (enviable) challenge of putting found money to good use, far too many Americans fritter away their good fortune on frivolous buys. Worse, they gain a false sense of financial security and sink themselves further into debt.
“If you haven’t had to work for the money, you may not value it as much,” said Ryan Fuchs, a certified financial planner with Ifrah Financial Services in Frisco, Texas, in an interview. “A lot of lottery winners lose it all or a good portion of their money in three to five years.”
Even small money windfalls, he said, can deliver big dividends if used to make debt disappear, fund a down payment on a first-time home, or invest strategically for future returns. In some cases, people reach out to a financial professional to understand the options.
Money windfall patience
Don’t upgrade your car, don’t buy a beach house, and whatever you do, don’t quit your day job. Such money moves may all be possible in time, but prudence at the outset will help ensure your options remain open until you determine where your financial priorities lie.
“The first thing I suggest is to do nothing, because emotions may be running high and that is rarely a good time to make major decisions,” said Fuchs.
Remember, too, that if Uncle Sam is involved, the size of your financial windfall may be smaller than you think. Before you spend any money, you’ll need to assess your tax obligation.
Generally, any property you receive as a gift, bequest, or inheritance, as well as damages awarded for physical injury or physical sickness, are considered tax-free, the IRS reports.1
Bonuses from your employer and winnings from gambling or playing the lottery are taxed as ordinary income.
The best first step for found money is to rid yourself of high interest debt, said Michael Witty, a partner and certified financial planner with Chicago-based law firm Handler Thayer, in an interview.
Paying off credit card balances, which often carry interest rate fees of 18 percent or more, offers the biggest immediate benefit, followed by student loans, and home equity lines of credit.
“You’re never going to regret paying those down,” said Whitty. “Many times, the interest you’ll save is a better return on investment than what you might earn in the market.”
The average U.S. household that carries credit card debt has a balance of $5,944, according to a 2022 survey by Nerdwallet.2
At 18 percent interest, if only the minimum (interest plus 1 percent of balance) monthly required payment were made, it would take roughly 24 years to eliminate that debt, with total interest charges of more than $8,000, according to the online debt calculator from personal finance website Bankrate.com. That’s assuming no new debts were incurred.
On the financial road of life, you’re bound to encounter a pothole or two. To ensure that a bout with unemployment or unexpected medical expenses don’t derail your long-term financial goals, it’s important to set aside at least three to six months’ worth of living expenses in a liquid, interest bearing account, said Fuchs.
The self-employed and those with less job stability need a bigger cushion still, anywhere from 12 to 18 months’ worth of savings.
If you haven’t set that money aside, that’s the second order of business for your new pile of cash. (Learn more: Emergency fund basics)
Depending on your financial picture and the size of your sudden financial windfall, Fuchs says it may make sense to purchase life insurance and disability income insurance coverage, as well, to protect your loved ones. Life insurance helps protect your loved ones if you die prematurely, while short-term disability income insurance pays a percentage of your salary if you become too sick or injured to work, he explained. (Calculator: How much life insurance do I need?)
The Social Security Administration notes more than one in four of today’s 20 year-olds will become disabled before they retire, most often due to back injuries, cancer, heart disease and other illnesses that result in extended absences.3
Those who come into significant wealth, however, may not need the same level of protection, said Fuchs. “If you get a $2 million inheritance and you invest those assets properly, you may have enough in the bank that you don’t need to worry about life or disability insurance at all,” he said.
The trick, of course, is choosing investments wisely. As noted earlier, there are lots of tales about lottery winners ending up broke. That’s why many people opt to consult a financial professional to help consider all the options.
Once your safety net is secure, it’s time to focus on strategies that can help you grow your nest egg and provide for a comfortable retirement. (Calculator: How much should I save for retirement?)
Tax-favored retirement tools, such as traditional Individual Retirement Accounts (IRA) and 401(k)s, are funded with pre-tax dollars, and lower your taxable income in the year you contribute. Better yet, earnings grow tax deferred, which enables them to benefit from compounded interest.
For those who qualify, Roth IRAs offer another potential payoff down the road. Roths are funded with after-tax dollars, which yields no immediate tax deduction, but the earnings grow tax-free.
Even a small investment could yield enough money to increase your standard of living during your Golden Years. Or, it might be enough to expedite your retirement. (Related: Starting young and retirement math)
A 35 year-old who puts $30,000 into a traditional IRA and continues to contribute the annual maximum until they reach age 65, for example, would grow their retirement savings to $773,096, according to the AARP’s IRA calculator . That figure assumes a hypothetical 7 percent return and a 25 percent tax bracket pre-retirement.
The IRS allows you to contribute a total of $6,000 in 2022, $7,000 if you are 50 or older) to all of your traditional and Roth IRAs, plus an additional $1,000 if you are older than age 50.
The amount you can deduct from traditional IRAs, however, is subject to income limits, your filing status and whether or not your employer offers a retirement plan. Deduction amounts begin phasing out for single taxpayers with modified adjusted gross income of more than $68,000 a year and disappear entirely for those who make $78,000 or more. ($109,000 and $129,000 respectively for married filing jointly).4
You may also wish to create an income stream during retirement by purchasing an annuity with your windfall, especially if you’ve fallen short of your previous savings goal.
Annuities, which are effectively contracts between you and an insurance company, help make sure you don’t outlive your savings by providing retirement income in exchange for either a lump-sum payment or series of payments. (Related: Does an annuity fit your retirement goals?)
Any remaining money after your retirement goals are met can then be invested in taxable accounts for growth.
The Rule of 72, a widely used shortcut for estimating investment returns, dictates that investors will double their money roughly every 10 years when a 7 percent annualized return is assumed.
“Even a small amount invested wisely can yield a very significant long term benefit, especially if you come into a windfall when you’re young,” said Fuchs. (Related: How to grow wealth)
There’s no one asset allocation that’s right for everyone, of course.
Most investors require the expertise of a financial professional who will factor in their short and long-term goals, time horizon and tolerance for risk.
Those who are tempted to keep their money under the mattress to avoid Wall Street volatility, or park their financial windfall exclusively in fixed income (bonds), should think again, said Fuchs.
An overly conservative portfolio guarantees a loss of purchasing power, as inflation chips away at principal. Even after they retire, investors should consider whether their asset allocation is sufficiently balanced for growth, he said.
Saving for your kid’s college education should never supersede your own financial goals. After all, there are no scholarships or low-interest loans available for retirement.
But if your financial nest egg is fully feathered, and you’d like to lessen the burden of student loans for your college-bound kids, you may want to park a portion of your windfall in a 529 investment account. Such accounts are funded with pre-tax dollars and earnings become tax-free if used for qualified education expenses. (Calculator: How much do I need to save for college?)
The other option is to invest that money in your retirement accounts, especially if you think your child may decide not to pursue a higher degree. Money in an IRA can be used penalty-free to pay for qualified higher education expenses, or left there for your own retirement if it isn’t needed. You may also be able to borrow from your 401(k), depending on your saving’s plan’s terms.
Philanthropy and charity
You can also do ‘good’ with your windfall — for your tax liability and the charity of your choice — by gifting some of your money to a qualified nonprofit.
The IRS generally lets you deduct contributions to public charities, colleges and religious groups up to 50 percent of your adjusted gross income per year. Contributions to certain private foundations and other organizations are limited to 30 percent of AGI.5
“If your windfall is taxable, I always try to find a way to deliver more bang for the buck by structuring the donation to take full advantage of tax deductions,” said Whitty. (Related: The advantages of life insurance for charity)
By setting up a donor advised fund, for example, the donor is able to claim an immediate deduction in the year they contribute and distribute those funds to qualified charities over many years.
Finally, while financial discipline is prudent where found money is concerned, it’s important to note that a regimen that denies all frivolous expenditures is rarely sustainable. Don’t be afraid to treat yourself.
“If you’re too strict with yourself it’s a recipe for failure,” said Fuchs. “Splurge on something you’ve always wanted and get that out of your system. Once you’ve had a little fun with the money, you may be in a better position to save or invest the rest.”
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This article was originally published in September, 2016. It has been updated.
1 IRS, "Publication 525 (2019), Taxable and Nontaxable Income" Aug. 26, 2022.
2 Nerdwallet, “2019 American Household Credit Card Debt Study,” Jan. 11, 2022.
3 Social Security Administration, "Helpful Facts About Social Security Disability Benefits,” July 21, 2021.
4 Internal Revenue Service, “IRS announces changes to retirement plans for 2022,” Nov. 17, 2021.
5 IRS, “Charitable Contribution Deductions,” Aug. 25, 2022.