How to Handle an Unexpected Financial Windfall

Credit: Illustration: Zain Awais

A financial windfall can come in many forms: inheritance, a trust, stock options, winning the lottery, and to a lesser extent, government relief checks. It’s very common for people to spend much or all of a windfall right away, leaving them little to show for it. It’s crucial to take things slow and make intentional, smart decisions about what to do next. I spoke with Mitch Mitchell, associate counsel at Trust & Will, to find out the key steps to take if you suddenly fall into a lot of money.

Why a plan matters 

Your windfall won’t last if you don’t plan for how you will preserve the money. As an example, a third of Americans will blow through an inheritance within two years and be left with negative savings. Even lottery winners are more likely to declare bankruptcy within three to five years than the average American, the reason being that when managing money isn’t already a strong suit, misspending will simply scale up to match the amount of money there is to spend.

According to Mitchell, the worst thing you can do is have no plan, mostly because you didn’t take a beat to think about your goals and values. Otherwise, you’ll have “taken a good thing and turned it into a curse.” Mitchell says an unexpected windfall should be a regret-free experience.

While your financial situation and the size of the windfall may vary, financial advisors commonly suggest the following items as part of your spending plan:

Assess your financial goals 

First, you’ll want to determine the net amount of your windfall and whether it’s taxed or paid out in installments, as that will affect your windfall spending plans. As an example, inheritance of a taxable asset can have complicated “set up in basis” tax implications, and inheritance of a 401(k) will have unique rules about when you have to take the funds. If the amount of your windfall is substantial, you might want to hire a financial planner to help you navigate through a plan that will minimize unnecessary taxes.

Mitchell lays out three main ways you can divvy up your lump sum. First is celebrating this windfall and setting aside a small chunk as “fun money.” Second is putting your money to work. For short-term goals, this means a high-yield savings account, or some low-risk vehicle, like a CD or MMA. Third, put the rest of the money away for your longer term goals, like your retirement accounts or 529 plans for your kids' education.

Once you have a clear assessment of your windfall, reassess and prioritize your financial goals (saving for college, early retirement) against outstanding liabilities like debt. Again, your financial advisor can help you with this, as it can get complicated—you might strategically want to keep some (low interest) debt in order to further some of your larger financial goals, like building your retirement savings.

Pay off “bad” debts like credit cards or high-interest loans 

A windfall can be an instant boon to your ongoing monthly cash flow if you use it to pay off or pay down your “bad” debt. The opportunity cost is pretty straightforward: You get nothing for paying 16% annual interest on your credit card balance, but that monthly payment could be invested in retirement savings with, say, a 10% return that compounds over time.

Start or add to an emergency fund

The pandemic has been an object lesson in why an emergency fund is important, and a one-time windfall will not preclude you from needing a “rainy day” fund to pay for unexpected expenses, especially if you suddenly become unemployed. Putting money aside for three to six months of expected expenses is typically recommended, although if you receive a large windfall, you might want to bump that up to 12 months.

Play catch-up with your retirement accounts

According to Fidelity Investments, you should plan to save 10 times your income if you want to retire by age 67. The best way to do that is through retirement investments (either a 401k, Roth IRA, traditional IRA, or Roth 401k) that will grow with compound interest over the years. Also, some accounts allow you to “catch up” and contribute additional funds if you are over 50 or did not take advantage of the maximum contribution limits in prior years.

Set up a 529 fund for education spending

Similar to retirement funds, a 529 fund is a long-term investment that grows with compound interest over time, except that it’s designed for education spending. Money from the fund can be withdrawn tax-free and spent on qualified education expenses like tuition or books. You’ll get more bang for you buck if you invest in one of these funds early, so why not use some of your windfall to set up a 529 for a child (or yourself, if pursuing a new career is one of your goals)?

Take care of home repairs

Neglecting home repairs can end up costing you more the longer you put them off. You won’t get any tax deductions for most home repairs, but some of them—like fixing a leaky roof or faulty HVAC—are ticking expense bombs that can be avoided with an injection of capital early on.

It’s okay to splurge a bit 

Again, this depends on your financial situation and the size of your windfall, but it’s also okay to splurge—within reason. A common rule of thumb among financial advisors is to spend 5% of your windfall on whatever you want, providing that you’ve taken care of your debt and put money toward your financial goals. If you’re feeling generous, you can also make tax-deductible donations to charity, or give directly to another person, like a friend or family member. You can gift up to $15,000 per individual before you have to pay gift taxes.

Assemble a team of advisors

Sit down with an accountant, financial planner, and lawyer. Make sure they are people you trust who have expertise in managing large sums of money and helping lottery winners and inheritors. They will help you create a money management strategy, set financial goals, choose investments, establish trusts, potentially plan charitable giving and ensure your taxes, estate and assets are all properly arranged.

A good recommendation from a trusted friend or family member can go a long way, but if you want to vet the reliability of your advisor (and you do), you should start with NAPFA, the National Association of Personal Financial Advisors. For more, here's our guide to finding a financial advisor who won't rip you off.

Stick to your plan for responsible spending

Again, do allow yourself to spend some of the money enhancing your life and bringing joy. Just set a reasonable budget for non-essential, quality of life spending. For example, you might allocate 10% towards a dream vacation, home renovations, donations to charity, helping out family, or even buying something fun like a boat. If you have no immediate use for these funds (like eliminating debt), Mitchell says this is where a professional will guide you to make the right investments for you.

Following these steps will help you manage a financial windfall responsibly by educating yourself, relying on professionals, eliminating debt, focusing on smart investments and saving, and budgeting wisely for some discretionary spending. Making intentional money decisions will allow you to steward your windfall effectively. For more tips on all kinds of estate-planning topics, check out Trust & Will’s resources here.