Whether you’ve won the lottery, inherited a fortune or sold your business, landing a financial windfall can drastically improve your financial outlook. But the sudden wealth can also leave you stressed and unsure how to handle the cash.
First, hit the pause button, says Don Hance Jr., founder of LifeSighted, a financial planning company. Take time to create a spending plan to avoid making poor decisions.
“You want to give yourself time to take stock of everything and work through emotions before spending the money,” says Hance.
Here are five smart ways to allocate a financial windfall.
1. Cushion your nest egg
Maximize your 401(k) contributions if you still plan on working, or at least contribute enough to earn the full employer match, which is essentially free money for your retirement. As you put more money toward retirement, the windfall will fill that gap in your cash flow.
This move also carries tax benefits: contributions are taken out of your paycheck pre-tax, lowering your taxable income for the year. Investments grow tax-deferred until withdrawals at retirement.
Also, look into funding a Roth IRA if you’re eligible, says Mark McCarron, a financial planner and principal at Bond Wealth Management, LLC. Contributions to Roth retirement accounts are made after-tax, and your investments grow tax-free. Unlike a 401(k), there’s no income tax on withdrawals made in retirement.
“It is one of the only free lunches the IRS gives us,” McCarron says.
2. Pay off toxic debt
If you’ve been trying to pay off debt, this is an opportune moment. Pay off toxic debt with the highest interest rates first, such as credit cards, payday loans, title loans and installment loans.
For example, a credit card with a $10,000 balance at 20% interest would cost $11,680 in total interest if you made $200 monthly payments. It would take more than nine years to repay the debt.
Use your windfall to pay the balance in full, and you’ll save interest.
3. Build an emergency fund
An emergency fund is money set aside to cover unplanned expenses, such as car repairs or a job loss, so you don’t have to rely on credit cards or high-interest loans.
A good rule of thumb is to have three to six months of expenses saved, says McCarron.
The amount to save depends on factors such as job security and how much debt you owe. Keep the money in a high-yield savings account, where it earns some interest and is readily accessible.
4. Invest in yourself or a loved one
Investing isn’t limited to your retirement; you can also use some of the windfall toward self-development. Go back to school, hire a career coach, travel or learn a new skill.
Consider starting a 529 savings plan to support a child, relative or friend through college, says Levi Sanchez, financial planner and co-founder of Millennial Wealth, based in Seattle.
The plan provides tax-free investment growth and withdrawals for qualified education expenses, such as tuition, fees and books. Most states also offer a tax break for residents.
Under the current tax law, 529 withdrawals up to $10,000 per year can be used for tuition costs at elementary or secondary public, private and religious schools. Check with your state’s plan before making withdrawals for this purpose; not all states have adopted the changes.
5. Give back
Consider making charitable donations to an organization or social cause you support.
Your gift can positively impact the organization, but unless it’s a sizable donation, it may not help your taxes. That’s because you need to itemize your taxes to get a deduction, and itemizing only makes sense if your deductions add up to more than the standard deduction.
For 2018, the standard deduction is $24,000 for married individuals filing jointly or $12,000 for single individuals. Maintain records of your contributions if you donate.
Giving money to family and close friends doesn’t carry tax benefits. But if you’re feeling generous, you can give up to $15,000 per individual in 2018 without having to file a gift tax return, says Sanchez.
A financial planner or tax professional can provide further guidance on managing a windfall.