How To Invest A Windfall

Goals, Theory

Every once in a while life takes the opportunity to throw you a curveball and dump some good financial fortune in your lap.  Whether it’s a bonus at work, a family inheritance, or a lucky night in Vegas, an influx of cash is generally a welcome sight.  But because of the rarity of these life events, most people are usually caught a bit off guard and are unprepared for what to do next.  Set aside for a moment the fantasies we all have about crazy things we might do if we won the mega lottery — what exactly is one supposed to responsibly do with a financial windfall?

This question is also personally relevant to me right now.  If you’ve been wondering about my dwindling post frequency lately, have no fear.  I’m just fine!  In fact, I just sold my home in the burbs and moved into a great apartment in a fun part of town.  As anyone who has experienced the same process can attest, the move and sale were extremely time consuming.  But today the boxes are unpacked in the new place, the old house is sold, and I finally have the free time to write again.  And with a fresh check in-hand for the previous equity in my home, I’m facing the same problem myself.  What should I do with the money?

Well everyone is different, but here are a few things to think about.


Calculate your tax liability and set aside what you owe

Just because you have a lot of new money in-hand does not mean it all belongs to you.  Even if it’s not earned income from a normal paycheck, it still likely counts as income from a tax perspective and both your home state and the federal government will want to take their cut.  The last thing you want to do is to spend money that does not belong to you only to be caught off guard by the bill later, so the first step to managing a windfall is to figure out your tax liability.

Sometimes that’s easy.  Your employer may deduct taxes from your bonus for you so you don’t even need to think about it.  In my case, the proceeds from my home fall well below the deduction for taxable capital gains from a home sale so the income is tax-free.  But some situations like inheritances are tricky, and if you’re unsure of your own tax liability this would be a great time to talk to a tax adviser.  Spending a small fee now to avoid a large unexpected bill later is money well spent.

So what should you do with money you know the government will come for in short order?  Not immediately blowing it on cars and booze should be obvious, but I’ll take it one step further — don’t invest it in your normal asset allocation of risky assets.  It may seem like a no-brainer to invest the money and pay the tax bill out of the market proceeds, but what happens if the market crashes in the meantime?  The tax bill will be exactly the same as before but you will no longer have the original money to cover it.  Investing your tax liability is like investing on callable margin, and in my opinion unless your bill is very small relative to your assets it’s just not worth it.

But that doesn’t mean you can’t be smart about your unique situation and make a little money for your effort.  As an alternative to risky stocks, consider taking the money you owe the government and putting it in an interest-bearing bank account or perhaps a low-risk treasury index fund.  You won’t double your money this way, but you will earn a few more dollars with no risk of being the last guy at the table stuck with the bill.


Pay your debts

Debt is an unfortunate fact of life, and too often people are swimming in it.  But it’s not just broke recent college grads who are financially handicapped by monthly bills.  In fact, I’ve known lots of high-net-worth individuals who have been so desensitized to debt over the years that they continue to pay interest to a third party even when they have absolutely no need to.  So even if you’re well-off and fully invested in the idea of “good debt,” take the opportunity with your new financial windfall to reevaluate your situation.  Living debt-free is an amazing feeling that opens up lots of flexible life opportunities, so let’s see what we can do to get you there.

As you look down your list of debts, I’d generally split them into three categories — personal, high-interest, and low-interest — and would pay them in that order.

Do you still owe your grandma for when she helped cover your rent a few years ago when times were tough?  She may be extremely patient and willing to not even charge you interest, but you should pay her back.  The social cost for lingering personal debts is far higher than any interest payment calculation, and that needs to be erased today.

Do you have any rolling credit card bills charging exorbitant interest?  Pay those next.  What about your car payment or an old student loan with a moderate interest rate that you’ve been making excuses for keeping while investing the balance in the stock market?  Just pay them off.  Market returns are uncertain but the money you save on interest payments is guaranteed.

Do you have a relatively low-interest loan that you legitimately think you can beat with your personal investments?  That starts to get into a gray area, and the financial blogosphere is full of debate on whether it makes sense to apply money towards investments or low-interest debts.  Rather than beat that dead horse, let me simply re-frame the situation.  Think of your windfall not as a cash payment to be optimized to the last penny but as a get-out-of-jail-free card from old debts that you won in a bank raffle.  Does that idea excite you and get you thinking about how it will positively impact your life?  Then pay off those debts and experience the joy of true financial freedom.


Fully fund your retirement accounts

Dedicated savers often have their retirement contributions on auto-pilot, as they set a certain percentage to be withheld from their paychecks and never think about it again.  This is a great way to do it, as forgetting about that extra money tucked away for the future helps fight the temptation to spend it on the here and now.  But it also pays to occasionally reevaluate that default savings plan, and the situation of a financial windfall is a prime example.

Contributing 10% of your paycheck to a retirement account is great, but an even better choice is to max out your contribution.  Not only will it save you in taxes today but it will also compound tax-free for decades and pay huge dividends later on once you start taking withdrawals in retirement.

There are two ways to do this with a big windfall.  First, you can contribute the max allowable amount to your IRA.  If you don’t know what that is, talk to your brokerage and they’ll be happy to help.  And second, while you generally can’t directly drop a check into your work 401k you can choose to max out the annual contribution taken out of your paycheck while living off the same amount of your new windfall money.  Either way, every dollar you invest in a tax-deferred account today will create many more in the future.


Top off your under-performing assets

So you’ve accounted for taxes, paid your debts, and maxed out your retirement savings.  Let’s assume you’ve even sprung for a drink at this point to celebrate your good fortune.  What’s the best way to allocate your windfall into your existing taxable investment portfolio?

We often talk about the importance of rebalancing in asset allocation and how it helps us sell high, buy low, and minimize risk overall.  But the one thing that sometimes gets lost in that discussion is the impact of taxes on the returns.  Every time you sell an asset the capital gains above and beyond the amount you originally paid for it are taxable, and if you’re not careful about it those taxes can quickly erode your hard-earned gains.  There’s a huge industry built around tax mitigation strategies, but anyone with a chunk of new money in-hand has access to the simplest and most effective method available — top off your under-performing assets.

By purchasing more of your under-performing assets to bring them back up to the desired percentages, you’ve accomplished the holy grail of tax management in investing — a tax-free rebalance!  So leave the complicated calculations packed away for next year and enjoy the time you just bought not having to worry about it.  In fact, if you’re not doing it already consider always buying the lagging asset with new earned income as well.  Life is too short to waste with tax planning strategies when the simplest option is staring you right in the face.


Consider buying that new asset you’ve been eyeing

Portfolio building isn’t necessarily about creating the perfect asset allocation from the start.  Sometimes the more prudent strategy is to build things up over time.  One piece of advice I like to give new investors is to not get too stressed out about finding the perfect portfolio and instead try buying a single total stock market index fund to get your feet wet.  After all, a good stock fund will be the foundation of any future asset allocation and you can always add more assets over time as you accumulate more money and become more familiar with your own financial needs.

Well, there’s no better time to add one of those new assets than when you have a large chunk of new money to invest.  There will be no taxes to pay for selling other assets, and you can establish a sizable position relatively quickly.  Now I definitely don’t encourage doing this hastily, but if you’ve been thinking about tweaking your asset allocation for a while then timing it with investing your new windfall could make a lot of sense.

As an example, I’ve been thinking for a while now about adding some REITs to my own portfolio.  It didn’t make as much sense for me before because I was already plenty exposed to real estate with my home equity, but now that I’m a renter REITs start to look more appealing.  While I haven’t made a final decision, the plan is to park a portion of the proceeds from the sale of my home into cash while I evaluate my options.  I’m in no hurry, but I recognize that the opportunity to easily establish a new investing position is something worth exploring.


Ignore people seeking to profit from you

As I mentioned earlier, everyone is different.  I believe the ideas above are generally universal, but if there’s ever any question in your mind about what to do with a financial windfall you should never hesitate to seek help.  That said, it’s worth noting that not all help is created equal and not everyone has your best interests in mind.  So I would be remiss if I didn’t at least mention what NOT to do.

Simply put — don’t blindly trust anyone who has something to gain from advising you.

This applies not only to people in your immediate circle who may smell a quick buck in the water but also to financial professionals.  If you need help on that front, here’s a very simple test: Are they paid a percentage of your money, do they get transaction fees from your trading activity, or do they get paid by a third party for directing you to their services?  If the answer to any of these is “yes” or if they can’t give you a straight answer, then be very careful.  They may indeed be very smart people even with good intentions, but they’re probably not incentivized to have your best interests in mind.  At the very least, find someone who works for a flat fee to sit down with as a sanity check.  They tend to be straight-shooters and can help you make solid decisions without worry that all they want is a piece of the action.


Whew!  You just fell into a bunch of money and thought you had it made, and here I am making it all complicated.  My goal is certainly not to confuse you but to help you navigate a complicated topic that you’ve probably never thought about at all before you needed the info.  If it seems overwhelming, just take a deep breath and take your time.  That goes double if your windfall is tied to an emotional event like the death of a family member, as good choices are nearly impossible to make while you’re grieving.  No matter what, never feel rushed to make a decision.  Measure twice, cut once, and you’ll be just fine.

As rare as they are, many of us do receive windfalls at some point.  Here’s to hoping that sharing my own experience will help you through yours.  It takes a bit of smart planning, but the good choices you make today will pay even bigger dividends tomorrow.  So even if your personal windfall is only hypothetical right now, take a few minutes to think ahead to how you might handle it.

Given the opportunity, what steps will you take to put your good fortune to productive use?