What should I do with this tax refund/bonus/other windfall?
You’ve just received a financial windfall. Congratulations! Whether it is $500 or $500,000, a windfall can feel life-changing. You may be feeling euphoric now but according to Reader’s Digest, 70% of all Lotto winners lose or spend all of their windfall within 5 years or less. You can spend the money much faster than you expect so proper planning is important.
The type of windfall you’ve received may determine your first step. A settlement, bonus, or lottery winning may increase your tax bill for the year so setting aside enough to pay taxes is important. Consult with a tax professional if you are not sure about the tax treatment of your windfall.
If you’ve received a significant tax refund, you may be over withholding throughout the year. While it isn’t as thrilling as receiving a lump sum, reducing your tax withholding on your paycheck will free up more cash flow throughout the year which may make certain goals easier to meet.
In most US states, lottery winners cannot remain anonymous. This means that if you have won a large jackpot, you may have fourth cousins or old friends coming out of the woodwork to remind you how much they mean to you. Setting your social media accounts to “private” is a must in this case.
Whatever the source of your windfall, waiting to decide how to use the funds (if feasible financially) is the best thing you can do. This allows time for the euphoria and whirlwind to fade and for you to sit down and think through your financial goals.
Priority One (Part One): Pay Down High-Interest Debt
Credit card and student loan debt usually carry higher interest rates than other types of debt. Paying down your credit card balance will save you money otherwise wasted on interest. If your windfall is large enough to pay off your student loans entirely, that will free up monthly cash flow you can put into savings or use to achieve other goals. In general, paying off debt with an interest rate higher than what you can expect to earn by investing is a good financial decision.
Priority One (Part Two): Build Up That Emergency Fund!
You may notice this is still priority one. Depending on your situation, building up an emergency fund may be more important than paying off student loans or other debt. Call us for more perspective on your particular situation.
While this does not bring the relief of paying off that high-interest credit card nor the thrill of buying something fun, creating a healthy emergency fund may save you in the event of a serious medical event or job loss. A healthy emergency fund is one with a balance equal to at least six months of expenses. Since this money may be needed at a moment’s notice, it should not be invested into anything with higher volatility than cash or an ultrashort-term CD.
Priority Two: Other Debt
You may have a car loan or a mortgage that you are itching to pay off. For some, debt weighs heavy on the psyche and can cause a lot of distress. Paying down debt with a mid-range interest rate may pay off financially as well as psychologically.
Priority Three: Increase Your Retirement Contributions
If you are not currently maxing out your retirement contributions, your windfall may give you the ability to do so. Your financial advisor or human resources department will tell you the limit for your retirement account. You may need to fund 30 years or more of retirement spending and Social Security will likely not be enough. Social Security benefits typically replace only 40% of pre-retirement income. Putting more away now can help ensure your comfort in retirement.
Priority Four: Saving for Other Goals
This windfall can give you a jump-start in saving for that big vacation, car replacement, or down payment on a home. It may make that once-elusive financial goal seem more in reach, which can motivate you to work harder to put away even more. Separating this “goal” money from your checking account may keep you from spending it down on lower priorities. Consider opening a separate savings account for your “goal funds” either at your current bank or at a different bank entirely.
Priority Five: Treat Yourself (Within Reason)
We’re not suggesting that you treat your windfall as all work and no play. Feeling deprived can reduce your motivation to save. A windfall can be transformational but if you don’t feel any immediate benefit from it, you may feel less optimistic than before the money came into your life. If your windfall is substantial enough, start by choosing something relatively small which has felt out of reach. This may be an addition to your wardrobe, a weekend away, or a new tech gadget. Choose something you will appreciate and use for more than a few days.
Your specific priorities depend on your own situation and this list can only provide general guidelines. For a conversation about options for your windfall, call American Money Management and speak with one of our financial planners.