Who hasn’t dreamed about getting a financial windfall? Maybe you hit the lottery…received a large insurance settlement or a lump-sum pension payout…or a relative left you a sizable inheritance.
The reality of managing sudden wealth is far different from the fantasy, says Susan K. Bradley, CFP, a financial advisor who specializes in clients who come into large sums of money. Most windfalls aren’t enough to set you up for the rest of your life—they typically range from $50,000 to several hundred thousand dollars. But even those amounts can stir up personal-finance conflicts over saving and spending…reducing debt versus investing…and what to do if family members and friends ask for handouts. It’s easy to make financial choices that you later regret or suffer what Bradley calls “sudden money syndrome”—that’s when you’re more likely to fritter away money you didn’t earn than money you did.
The key with a financial windfall is to take your time and use the money to enhance your sense of well-being and create a more lasting impact on your life. Here are the mistakes to watch out for when dealing with sudden wealth…
Mistake: Being unclear about the taxes you owe. No one wants to think about taxes when they come into money. But if you don’t get a clear handle on what you owe the government and plan ahead, you risk surprise penalties and bigger tax bills, either because you don’t follow the rules or ignore tax-reduction strategies. What to do…
As soon as possible, work with your accountant to figure out how much of your windfall is taxable, at what percent and when payments are due. Different types of windfalls can trigger very different tax liabilities. Examples…
Inherited IRAs. Heirs can lose much of their inheritance if they don’t follow the rules for handling these accounts.
Inherited stock, real estate and collectibles are not counted as gross income for tax purposes. They get a stepped-up basis to the asset’s value at the date of death—not the original price at which the deceased acquired the asset. But future gains on those asset(s) will be taxed at your prevailing capital-gains rate at the time of the sale.
Lottery wins. If the amount is over $5,000, the federal government typically withholds 24% of your winnings immediately—but you may owe additional federal and state taxes.
Life insurance proceeds. Except for interest, the proceeds generally aren’t taxable.
Lump-sum pension payouts are considered ordinary income and can reduce your eligibility for other tax deductions and benefits.
Alimony and spousal support from a pre-2019 divorce generally are treated as ordinary taxable income for the spouse who receives it.
Mistake: Making immediate decisions about your sudden wealth. When people misuse or squander a windfall, it’s often due to impulsive choices they make soon after they get the money. Reason: Powerful emotions surrounding the money can distort decision-making. Moreover, many people treat money that they have earned differently than “found” money, which is easier to spend frivolously or invest without a plan. What to do…
Avoid any big financial decisions for three months or longer. The duration of this period can vary based on you and your specific circumstances, but it should be a long enough period for you to process your emotions and consider what you really want to accomplish with the windfall.
In the meantime, park the money in a safe interest-bearing account. It’s relatively easy to get an annual return of 4% to 5% in a high-yield savings account or money-market fund. If you fear you’ll dip into the money, put it in short-term certificates of deposit (CDs) or US Treasury bills, so that it is harder to access.
Review your current financial plans, and use the money to make meaningful progress toward the goals and values that are important to you. This may include paying off high-interest debt or your mortgage…taking care of home repairs or improvements so you can age in place…having medical procedures you have been putting off…beefing up your retirement and children’s educational contributions.
Create a “bliss list.” This is a list of desires that may now be within reach thanks to your windfall. If you have a partner or spouse, you each should make separate lists and then compare notes. Ask yourselves, What is really important to me?…Where do I want to be in five years? In 10 years? In 20 years?…What have I always wanted to do but never had the opportunity to do?…Whom do I want to help?…What do my perfect day and perfect year look like?
Mistake: Spending too much on luxury goods. Treating yourself to big-ticket items like a car or vacation home isn’t necessarily a “wrong” decision. But just because you can afford to fulfill a lifelong desire doesn’t mean that it will give you the satisfaction you expect. Many people who spend sudden money on luxury goods find the thrill wears off very quickly. Example: One windfall client purchased a Porsche 911—it had been his dream since his teens. But he was a very large man, and the Porsche was so uncomfortable to drive that it ended up sitting in his garage. What to do instead…
Before you make a luxury purchase, imagine your level of satisfaction a year or five years from now. In general, we derive much greater long-term satisfaction from experiences such as a trip around the world with family members rather than goods that start depreciating almost immediately.
Indulge the impulse to reward yourself—but do it in a rational way. Then it won’t turn into a five- or six-figure mistake. Example: Buy anything you want, but limit yourself to 5% or 10% of the windfall amount. And before you purchase a luxury vehicle or vacation home, rent or lease one first to see if the magic lasts.
Mistake: Making promises to give away money to family members or friends. Many of my sudden-money clients receive great pleasure from giving away money. But windfalls have a way of turning up long-lost friends who feel entitled to a portion of your money…or creating deep resentment if you give to some family members and not others. What to do…
Postpone gifting until you have a firm grasp of your new financial position. You don’t want to make promises that you later have to alter or renege on if it turns out you need the money. Prepare a statement to send to family/friends who e-mail you for money (or keep it handy so you can refer to it if they call). Example: “My newfound wealth has been overwhelming. I appreciate you giving me the time and space to find my bearings before I make any decisions. I am still learning about the tax consequences and other new requirements that come with money, so I am not in the position to make any gifts, loans or investments.”
Clarify your giving strategy. Determine an amount you can safely give away. If you reject someone’s request or give more to one child than another, articulate your reasons in honest, straightforward terms. In general, it’s better to make outright gifts instead of investments or loans that can compromise relationships if the money is not paid back or is lost.
Mistake: Listening to unsolicited advice. Windfalls can draw a slew of solicitations from stockbrokers, insurance salespeople, real estate agents and other advisors pitching opportunities. You might be told that you are now an accredited investor who is eligible for investments reserved only for big-money people, such as private placements, limited partnerships and venture capital deals. At best, the individuals who approach you lack an understanding of your financial situation or goals…at worst, your well-being is not their primary goal. What to do…
Always solicit an advisor yourself, preferably one who has experience helping individuals with sudden wealth. Start by asking for recommendations from a professional you already trust, perhaps a longtime accountant or attorney. You can search for and vet financial advisors through organizations such as the National Association of Personal Financial Advisors (NAPFA.org)…the Garrett Planning Network (GarrettPlanning
Network.com)…and the Financial Transitionist Institute (FinancialTransitionist.com). Consider a certified financial planner (CFP)—that certification requires rigorous education and thousands of hours of work-related experience. Make sure the advisors are financial “fiduciaries,” which means they are legally bound to put your best interests first in the work they do for you.
