Winning the lottery may come with 300-million-to-one odds, but other types of financial windfalls such as a life insurance payout, a generous family gift or inheritance are not uncommon.
But a sudden influx of assets can also lead to missteps that could undermine your good fortune, cautions Terri Lyders, vice president, advanced planning for Fidelity Investments. First, do nothing with the majority of the newfound liquidity, she suggests. "It may be tempting to give money away to family and friends, adopt spending patterns that you can't sustain, or ease up on saving too soon," she cautions. "It's important to take the time to figure out how this money fits with your long-term financial goals." However, she notes, you may want to allow yourself to use a small piece of it to splurge on something fun or important to you.
First, you may consider taking advantage of today's higher interest rates by moving any cash you've received into something like an interest-bearing savings account, short-term CD, or a money market fund. "There's no reason not to enjoy a decent return for the time being while you take time to consider potential opportunities," Lyders says. She outlines 4 steps to follow next.
1. Get a handle on taxes and other potential costs
A windfall may not be all yours to keep. Proceeds from the sale of a business and bonuses will likely be subject to state and federal income taxes. And while life insurance payouts and gifts and inheritances (with some exceptions as noted below) are generally free of federal and state income taxation, several states levy inheritance taxes for as much as 16%.
If you inherit a 401(k) or traditional IRA, you may be required to take full distribution of the account within a certain amount of time, usually 10 years (unless you are a surviving spouse or other limited exceptions), and those distributions will be taxed as ordinary income. Stocks and bonds in a brokerage account, however, generally get a step-up in cost basis if the assets have appreciated as of the date of the former owner's death, so you likely won't pay capital gains tax if you sell them right away.
A real estate inheritance may merit special consideration. If you decide to sell the property you will likely owe capital gains taxes only on the difference between its value when you inherited it and when you sell it. However, heirs are often tempted to keep homes in the family, perhaps as a vacation home or to gift someday to their own kids, explains Lyders. In that case, consider what additional expenses you may be taking on—property taxes, insurance, upkeep, and travel expenses if it's far away. "It's important to be realistic about whether you can handle those expenses, now and over the long term," says Lyders. If you're considering renting the property to help offset expenses, try to be realistic about how much of the costs would be covered by rental income.
2. Decide which goals to prioritize
"Take care of yourself first," suggests Lyders. After you assess how much you will receive after taxes, put pen to paper (or keyboard to computer screen) and create an updated net worth statement and cash flow projection. First, consider topping off your emergency fund, and paying down any high-interest debt. From there, you can decide which long-term savings goals to focus on. For example, how much should you put toward retirement or college savings? Does your new cash flow allow you to boost other types of savings, such as 401(k) or IRA contributions?
If some of your windfall is in the form of stocks and bonds, you'll need to decide what to sell or keep, since some holdings might complement your existing portfolio. Your overall investment strategy may shift too. If you have an aggressive allocation suited for wealth accumulation, for example, you may want to dial it back to focus on capital preservation. Or the additional assets may offer the opportunity for you to take some additional risk, especially if you intend to pass some or all of the assets down to future generations. "A windfall could open a wider universe of investment options that involve less liquidity and taking greater risk for higher potential return," says Lyders. A financial professional can offer suggestions for how you might shift your strategy to help meet your long-term financial goals.
3. Clarify your giving strategy
Be aware that you may receive requests for financial help from family or friends, warns Lyders. And while you may want to share your good fortune, "what's important is that you have well-thought-out strategy for how much you can afford and are willing to give, and to whom," says Lyders. In general, it may be better to make gifts instead of loans that may not be paid back. "Going down the lending rabbit hole can disrupt relationships as well as your own plans," she explains.
In 2023, you can gift up to $17,000 per year to a single person without it counting toward your lifetime gift tax exclusion, and a couple can gift up to $34,000. You can make additional gifts above these limits: however, they will use some of your lifetime gift exclusion amount (which is $12.92 million in 2023) and requires the filing of a federal gift tax return. One exception: With a 529 plan, you can front-load five years' worth of gifts and contribute a lump sum of up to $85,000, or $170,000 for a couple, a technique known as accelerated gifting.*
You could also use a gift to help family members meet their financial goals. Lyders worked with parents in the San Francisco area who helped their adult children buy a house nearby that would ordinarily be out of their price range. "The parents were extremely happy to help their children when they needed it most," says Lyders. "They received tremendous emotional satisfaction from bestowing part of their unexpected windfall on their children."
You also may want to use your windfall to support charitable organizations that you care about. There are options such as a donor-advised fund, suggests Lyders, which allows you to take an immediate tax deduction and make ongoing annual gifts in future years. A tax attorney or financial professional can help suggest options for meeting your charitable goals in a tax-efficient way.
4. Revisit your estate plan
Anytime your financial picture changes, you should take a fresh look at your estate plan. That means reviewing—and perhaps revising—your core estate documents (such as a will, revocable trust, and power of attorney) as well as the beneficiaries on your life insurance or retirement plans. Take a look at who is named to step in and manage your finances in the event you become incapacitated or pass away, and whether you want to reconsider how your assets would be distributed after death. In some instances, you may feel that you want to include other family members, friends, or charities in your estate plan that you may not have already included.
A financial windfall can be something that has a positive impact on your life, but it can also bring with it some potential pitfalls. An initial pause when the windfall is first received, being intentional about your decisions, and creating a long-term plan for investing, spending, and perhaps gifting can help ensure that this lucky break not only brings you happiness and financial comfort in the near term, but also for years to come.