Many people think a financial windfall is rare, like winning the lottery. However, windfalls are more common than many think. They can come from various sources, such as life insurance policy payouts, profits from selling a home or business, or inheriting assets.
A financial windfall presents both an opportunity and a challenge. While it’s a chance to boost your financial health, it also demands savvy strategic planning to minimize taxes and maximize returns.
Step 1: Evaluate Your Financial Position
Before making any moves, it’s important to examine your current financial situation. Get a clear picture of your income, expenses, debts, assets, and long-term goals. This will help you make strategic decisions aligned with your personal needs and goals.
If you have debts, particularly high-interest debt like credit cards, it’s worth paying these off before looking into investment opportunities. The compounding interest on these debts can be a silent wealth drainer, and clearing them will improve your overall financial health.
Also, if you don’t have an emergency fund already, you’ll want to start one. The general rule of thumb is to have about three to six months’ worth of living expenses tucked away. This fund should be readily accessible and liquid, ensuring you can reach it without hassle if an unexpected expense arises.
It is important to resist impulsive spending. Don’t splurge on major purchases or lifestyle changes until you have a solid plan in place. This money has the potential to improve your financial future, but it requires careful planning to ensure that it does.
Finally, take a moment to reflect on your long-term goals. Do you want to fund an education for your children or grandchildren? Are your retirement savings where you would like them to be? There are many things that can be done with a financial windfall, and it will be easier to make decisions if you’re clear on your broader objectives. A wealth manager can help model your assets and goals, providing a clearer roadmap for how to allocate your windfall effectively.
Step 2: Tax Planning
When you receive a significant sum of money, whether from an inheritance, a real estate sale, or any other source, it’s important to grasp how the cash influx will impact your tax situation. Of course, the nature of your windfall matters, as different sources can be subject to different types of taxes.
If it’s an inheritance, you might be looking at estate taxes, depending on the value of the estate and the laws in your state. While the federal estate tax only applies to estates over a certain threshold ($13.61 million for individuals in 2024), some states have lower thresholds or separate inheritance taxes. It’s also important to note that the federal estate tax threshold will revert to approximately $7 million at the end of 2025 unless new legislation is enacted.
If your windfall came from selling assets like real estate or stocks, capital gains taxes could come into play. The rate of these taxes depends on how long you’ve held the asset, your filing status, and your taxable income.
Income taxes are another consideration, especially if your windfall includes payouts from retirement accounts or lottery winnings. These are often treated as ordinary income and taxed accordingly.
You may be able to manage potential tax burdens strategically. For example, if you’ve sold real estate, you might explore a 1031 exchange, which allows you to defer capital gains taxes by reinvesting the proceeds into a similar property. Another strategy might involve spreading the receipt of your windfall over several years to avoid pushing yourself into a higher tax bracket in a single year.
To determine the taxes you may face and identify tax-saving strategies, it’s important to consult with a tax advisor. They can guide you toward strategies to reduce tax liabilities based on your specific situation.
Step 3: Make Strategic Investments
Once you’ve assessed your financial position and mapped out a tax-saving plan, you can focus on strategic investments to maximize your windfall. Most of the following strategies offer a dual advantage: they can provide tax benefits while providing growth potential. However, it’s crucial to balance these opportunities with the need for liquidity and access to your funds.
One key principle in this stage is diversification – the idea of not “putting all your eggs in one basket.” This approach will spread your investments across different vehicles, which can vary in liquidity and risk, ensuring a more stable and resilient financial portfolio.
Remember, the suitability of any investment strategy is highly dependent on your personal situation and goals. Your investment choices should align with your financial objectives, risk tolerance, and time horizon. A wealth manager can provide personalized guidance to help you select the right mix of investments for your needs and goals.
Boost Retirement Account Contributions
One of the wisest moves you can make with your windfall is to bolster your retirement savings. If you already have a retirement account, consider increasing your contributions. This not only secures your future financial stability but can also provide immediate tax benefits, as some contributions may be tax-deductible. However, be careful with retirement contributions, as some retirement funds are locked until retirement age, penalize early withdrawals, and have annual contribution limits.
If you exceed the income limits for a Roth IRA, a backdoor Roth IRA is an excellent option for tax-free growth. This strategy involves contributing to a traditional IRA and then converting it to a Roth IRA. The benefits include tax-free growth and withdrawals and no required minimum distributions (RMDs) – making Roths more attractive than traditional IRAs. This strategy is particularly effective if you receive a large, lump-sum payout and execute the Roth conversion within one year of contributing the funds to the traditional IRA. It is not ideal if the windfall is spread out over time or annuitized, as repeated conversions can be tax-inefficient.
Educational Investments
If supporting your children’s or grandchildren’s education is a priority, allocating a portion of your windfall to 529 plans or education savings accounts is a strategic move. These plans offer tax advantages and can help manage the ever-rising costs of an education. However, these investments can only be used for educational expenses, and penalties and taxes will be applied to non-qualified withdrawals.
Permanent Life Insurance
Permanent life insurance policies go beyond just providing a death benefit. They can be a powerful tool for wealth preservation and estate planning. These policies accumulate cash value over time, which you can borrow against if needed – offering a source of liquidity.
Permanent life insurance policies tend to have higher premiums than term life insurance. They can also be complex and require careful management but can be a suitable investment for those seeking a combination of growth, liquidity, wealth preservation, and estate planning.
Long-Term Care Insurance
Long-term care insurance is designed to cover expenses that are not typically included in standard health insurance, such as in-home care, assisted living, or nursing home care. These costs can be substantial and are often overlooked in traditional retirement planning. Premiums paid for long-term care insurance may be tax-deductible, but the primary advantage of this type of insurance is to safeguard assets and savings against the high costs of extended care.
Annuities
An annuity isn’t exactly an investment strategy but a financial product that provides a guaranteed income stream for a set period or life. You make a lump-sum contribution or a series of payments, and in return, the annuity provider will make periodic payments to you. They can be a wise choice in certain scenarios. For instance, if you receive a substantial one-time settlement, such as a personal injury settlement, an annuity can provide income and financial stability when regular employment income is not expected. It can also benefit individuals who have maximized other retirement savings options and seek a guaranteed income unaffected by market fluctuations.
When managing a financial windfall, the array of investment vehicles and strategies available can be as diverse as they are complex. Each vehicle and strategy comes with its own set of features, benefits, and considerations. It’s important to understand that there is no one-size-fits-all approach, and the most suitable strategy will depend heavily on individual circumstances. As such, it’s advisable to speak with a qualified financial planner who can provide personalized guidance.
Step 4: Estate Planning
Estate planning and asset protection strategies should be integral parts of your overall financial plan. These strategies complement other investment choices and are essential for safeguarding your accumulated wealth.
Due to the complexity and legal intricacies of setting up and managing asset protection trusts, it’s essential to seek expert legal and financial advice. There are costs associated with establishing and maintaining a trust, particularly if they require a third-party trustee. These costs should be weighed against the potential benefits and protection they offer.
Get Professional Advice
While this article provides a structured overview of steps to take when navigating a financial windfall, this guidance is more of a foundational framework than a comprehensive solution. Each financial journey is unique, and the complexities of wealth management require a tailored approach that can only be addressed through personalized expert advice.
For a strategic approach to managing your wealth, enlist the expertise of a skilled advisory team. This team should ideally consist of an attorney for legal guidance, a CPA for tax planning, and an investment advisor for financial strategy. Together, they can ensure that your financial plan is robust, tax-efficient, and aligned with your long-term objectives.
Whether or not you have received a financial windfall, our expert tax and financial planning advisors will work closely with you to develop a customized plan that paves the way for a secure and prosperous future.