8 Smart Ways to Handle a Financial Windfall
Most of us dream of striking it rich with a financial windfall like winning the lottery or inking a Hollywood movie deal — and some people’s fortunes really do change overnight.
Whatever the circumstances that give rise to a source of newfound wealth, it’s more important than ever to make sound financial decisions and avoid some pitfalls.
You might suddenly find you have an urge to splurge, have friends seeking handouts or find yourself a magnet for fraudsters — any of which can lead to a money blunder. Just ask the numerous lottery winners who squandered their riches and ended up broke.
An estimated 70 percent of people who receive a financial windfall — a large amount of sudden money — won’t have any left within a matter of a few years, according to the National Endowment for Financial Education (NEFE).
“There is a perception you will never have to worry about money again,” said NEFE spokesman Paul Golden. “It’s the opposite. You have to worry more than you did before.”
Millennials getting their first signing bonus or receiving an inheritance are especially vulnerable to sudden wealth traps because they may not have formed wise money habits yet.
Here are 8 steps investors of all ages can take if they are fortunate enough to come into a sizable sum of money.
1. Catch your breath.
When money unexpectedly lines your pockets, it’s tempting to think about quitting a job or making a major purchase. But those would be dangerous moves if you didn’t fully understand the limits of your new wealth.
“Even a large windfall is unlikely to be life-changing,” said Anthony Webb, a senior research economist at the Center for Retirement Research at Boston College.
Lottery winners, for example, often overestimate their newfound wealth, Webb noted. The income from investing a million-dollar prize might only pay out $20,000 to $30,000 a year.
“It’s nice, but it won’t keep you in luxury,” he said.
That’s why it’s important to have a cooling off period of six to 12 months before taking any action, Golden said. During that time, it may pay to park the newfound money in a relatively safe investment, such as a certificate of deposit.
2. Think long term.
Think of your windfall as a lifelong asset that will help you build a secure financial foundation, the Financial Industry Regulatory Authority (FINRA) suggests. If you think about it as a long-term asset, it’ll help you ensure that the extra cash is still there to help you over your lifetime.
To do that, you need to put your emotions on hold and come up with a plan to manage this found money for the long haul. How to do that? Well, first…
3. Get organized.
Get a handle on your current financial situation. FINRA recommends gathering your personal and financial documents, including monthly bills, bank statements, brokerage firm statements, credit card bills and loan documents.
When that’s done, assess what you have, what you owe, the type of payment coming to you from the windfall and any other income you have to cover your daily expenses.
It’s also important to get a handle on just how much this windfall will be worth. Sure, the lottery or bonus payout might say “$1 million,” but after taxes and fees, you’re likely to end up with far less.
4. Zap high-interest debts.
The phrase “put your money to work” doesn’t apply only to investing. Sometimes, the best thing to do with found money is to start paying off debt.
Say you have a $3,000 balance on a credit card that charges an 18 percent annual percentage rate (APR) and requires a minimum payment of 2.5 percent a month. It would take a whopping 263 months — close to 22 years — to pay off that debt if you’re only making the minimum payment. And carrying that $3,000 loan over that time would end up costing you $4,115.44.
If you use your windfall to erase your debt, you can save or invest the money you would have been paying in interest. Better for you to earn interest than pay it to someone else.
5. Invest in your future.
Make a list of your financial goals and estimate how much each will cost. Want to go on a fabulous vacation? Pay off “past due” bills? Get a degree? Buy a house? Save for a child’s education? Write it all down. Make sure you don’t forget about something that might seem too obvious to include, like your retirement.
If you don’t have a retirement account, consider setting one up. If your company has a 401(k) or other retirement savings plan, contribute at least enough to get the company match if a match is available.
Then, separate your goals into categories — short, medium and long-term — and set up savings and investment accounts for each one. It’s easy to think you’re saving enough money, but keeping separate accounts allows you to keep track of exactly how close you are to achieving each goal.
6. Consider assembling a team of advisors.
Plotting an investment strategy isn’t always easy or intuitive — particularly if you’ve never done it before. Consider hiring a financial professional such as a broker, investment advisor, accountant, insurance agent or financial planner to help manage your windfall and achieve your goals.
Since there’s a good chance your unexpected fortune will trigger a tax bill, you might also want to hire a tax professional. FINRA offers a summary of the various types of investment professionals you might want to consider.
Ask for recommendations from friends, family members or colleagues, especially those who have investing experience. But don’t just take their word for it.
Once you have narrowed down your options, check out FINRA’s BrokerCheck or the Securities and Exchange Commission’s Investment Advisor Public Disclosure database to learn about a potential advisor’s background and disciplinary history. You might also want to check with your state securities regulator.
7. Curb your generosity.
While it’s nice to be charitable, use your judgment when friends and relatives come calling.
If you don’t feel right making a loan, remember that you can offer to help loved ones in other ways. But it’s not necessary to make lengthy excuses or feel guilty. In the long run, your loved ones might be better off if you don’t give them a handout you can’t afford.
“If you are too generous, you may have to come back to them for help,” said Bruce McClary, a spokesman for the National Foundation for Credit Counseling.
8. Protect your money from scammers.
A windfall — particularly one that others can find out about, such as some inheritances or a lottery win — can make you a target for fraudsters, so keep your guard up.
In addition to researching professionals and potential investments, you should brush up on the different types of fraud, how fraud happens, and learn the warning signs of fraud.
Red flags include promises of quick profits, “guaranteed” returns or pressure to spend money right away. FINRA’s Risk Meter and Scam Meter can help you determine if an investment or pitch might be a fraud.