The holidays were extra merry for at least two lottery players in the Chicago suburbs, who each won $1 million on scratch-off tickets last month.
While most folks can only dream of such luck, it’s not uncommon to receive an unexpected windfall worth a few thousand dollars this time of year thanks to a bonus from work or a tax refund. Others might receive an unforeseen inheritance or legal settlement.
Whatever the circumstances, such payouts can present an important opportunity to improve your financial security, but people often don’t know the best way to handle their newfound funds — and it’s easy to make costly mistakes.
If you’re suddenly managing an influx of cash, the following steps can ensure your newfound wealth doesn’t disappear as quickly as it arrived.
Don’t make any big decisions right away
If you’ve come into a large sum of money, it can be tempting to quit your job or give extravagant gifts to family members. Before moving forward, it’s important to take a step back and consider the short- and long-term implications of any financial decision you make now.
It may make sense to connect with a professional financial advisor who can help you think through the best way to use your new fortune most effectively.
“If you’re talking about any amount of money, anything that could be potentially life changing, your first, best call might be to an advisor, an accountant, or an attorney,” says Naveen Neerukonda, founder of PVA Financial in Oak Brook. “Or, if it’s a very, very large amount, call all three.”
Prepare for the tax hit, if applicable
The amount of taxes you owe on your windfall will depend on how you came by the money. You won’t owe taxes, for example, on a tax refund, but you’ll likely have to pay Uncle Sam for money received through a workplace bonus or a lottery win. In some cases, the organization issuing the cash, such as an employer or state lottery, will withhold taxes on your behalf, but it’s up to you to know your obligations.
“We see all the time, where someone gets a bonus and the employer withholds taxes, but they didn’t withhold the right amount because the bonus bumped them up into a higher tax bracket,” says Tim McGrath, managing partner of Chicago-based Riverpoint Wealth Management. “If they don’t realize that until next April, and they’ve spent all the money, that can be a problem.”
Once you’ve determined how much you could owe in taxes, set that portion of the windfall aside in a savings account where it can earn interest and there’s no risk of principal loss. Otherwise, you could find yourself scrambling at tax time next year.
Build up your rainy day fund
You should aim to have at least three to six months’ worth of nondiscretionary expenses such as rent, electricity and food set aside in a high-interest savings account that you can tap for emergency costs like home repairs or the loss of a job.
“You want those funds to be liquid, safe and accessible, and not invested somewhere that market conditions can affect them,” McGrath says.
Increasing this cushion means that when the unexpected does occur, you can dip into your emergency fund rather than turning to credit cards or borrowing from a retirement account.
Pay down high-interest loans
One of the most effective ways to use extra cash is to pay down existing debts, particularly on high-interest loans, such as credit card balances. As interest rates have risen over the past year, credit card debt has gotten even more expensive, so eliminating such debt will not only allow you to spend less on interest but also free up cash flow going forward.
“Credit card is like dead weight around your ankles that can sink anyone’s finances,” Neerukonda says.
Consider your medium- and long-term financial goals
Whether you’re looking to replace a car, put a down payment on a house or save for your kids’ college education, a windfall can provide an opportunity to accelerate your progress toward that goal. You might use the cash to offset an increase in contributions to tax-advantaged retirement accounts, such as an Individual Retirement Account or increasing your contributions to your workplace 401(k).
“A lot of times when people get an unexpected windfall, they just want to spend it, but it really is an opportunity to use that money to make a significant impact on their finances on a long-term basis,” McGrath says.
