Financial Planning Focus - How to Manage a Financial Windfall

November 29, 2016
By Kristan Anderson, CEBS®, CFP®

My father-in-law passed away almost a year ago, but it isn’t as if he left my husband some big estate. In fact, due to the circumstances around his demise, my husband wasn’t even named in any estate documents. We like to joke that our sole inheritance was a seven year-old golden doodle named Missy. She’s sweet, but way more maintenance than we are used to. As it turns out, there is a bit more coming our way, but still not enough to warrant serious planning. Or is it?

Any time someone inherits money, there is a temptation to spend it in ways that you wouldn’t necessarily spend your hard-earned dollars. Behaviorally speaking, an inheritance or other windfall can seem like “found money.” Experts suggest that the best thing to do when you find yourself with an unexpected windfall is to put it away in a savings account or money market fund for a period of up to six months. During that time, you have the opportunity to put together a plan on how to best use the money.

If you are looking at a substantial amount of assets, then consider putting together a team of advisors that may include a financial planner, accountant and maybe a lawyer or insurance professional. Working together, these professionals can make sure that you take into consideration all aspects of your inheritance, how best to use the money and the implications of making certain decisions.

If you only inherit insurance proceeds, you won’t have to pay taxes on the amount. But if you are looking at receiving all or part of a sizable estate, you need to consider the potential tax implications. For example, if you inherit an IRA, you will want to be mindful of the rules around beneficiary IRAs. The goal is to spread out distributions over your lifetime, versus having to distribute the balance, and pay the taxes on the distribution, over a five-year period. Again, if you take the time to consider how you want to use this windfall, you may be able to avoid immediate and direct tax consequences.

It may be tempting to quit working if you inherit a significant amount of money. While an inheritance may facilitate an early retirement for some, for others, it does little to offset the loss of earnings. The best thing to do when you receive a windfall, and are considering retiring as a result, is to run the numbers. Retirement projections can explore whether the increase in assets will effectively offset the loss of earnings, given spending levels and the amount of time needed to fund retirement cash flow. And remember, while you may be able to pull off an early retirement as a result of an inheritance, it is not likely that you can also afford a second home and a trip around the world. Pick your battles.

Depending on the amount of the windfall, you may be interested in making a grand gesture. Paying off loans and gifting money to family members may feel good in the moment. But unless these decisions help solidify your financial circumstances, you may want to reconsider. It is a good idea to use “found” money to pay off high interest rate debt, such as credit card balances. This is especially true if you are certain you won’t be building that debt up again in the future. Using a windfall to create an emergency fund, if you don’t already have one, is another good idea. Consider funding IRAs and 529 plans with a portion of your windfall. Both are considered an investment in the future.

My husband expects to receive a modest sum of money in the next few months as his father’s estate settles. It isn’t enough to engage a team of professionals or consider early retirement. Because technically it is a cash gift from the estate, we won’t owe any taxes on the amount, either. His father’s wish was that our family “do something fun” with it. So, we are planning a trip next spring, before our oldest heads off to college. But there might be some left over, and that is where the real planning will begin.