Windfalls are curious events. By definition, windfalls are large, oftentimes unexpected financial gains that most commonly result from an inheritance, a lawsuit, a property sale, lottery winnings, monetary gifts from family, or even a significant salary bonus. These events, of course, sound like a dream come true. Maybe now you can finally pay down your debt, fund the rest of your child’s college education, or even retire early. The “problem”—or rather, the challenge—for many individuals, though, is that a sudden influx of money can often lead to radical behavioral changes and poor financial decision-making.
Understanding how to handle windfalls effectively is crucial, especially when considering windfall taxes. When large sums of money are received unexpectedly, knowing what is a windfall tax and how to manage it can help preserve wealth.
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New Money, New Me? The Behavioral Side Effects of Sudden Money
Individuals tend to have different relationships with inherited or sudden money. In some cases, these behaviors are the result of not having had to work for the money themselves, and in others, the result of simply earning “too much, too fast.” Sudden inheritors of wealth often:
- Overestimate how far their windfall will go
- Miscalculate their spending power
- Give generous handouts to family and friends
- Quit their jobs
- Adopt a “YOLO” (You Only Live Once) attitude toward spending
Just take former NBA star Shaquille O’Neal as a prime example. Shaq ran through $1 million within 60 minutes of signing his first-ever professional athlete contract buying luxury items like cars and jewelry. In one hour, he spent more than some people make in a lifetime. But, research has found that it doesn’t matter if it’s $1,000 or $1 million—the pattern of squandering sudden money is the same.
Sometimes the overspending is a way to cope with loss, as is often the case when one receives an inheritance from a spouse or parent. Or, it is simply a relief valve opened too quickly after years of financial struggle. Whatever the situation, understand that it is not unusual to feel stressed or overwhelmed when you receive a windfall. Simply make sure to acknowledge the steps you can take to avoid becoming another statistic of suddenly inherited and suddenly lost wealth. Managing a windfall profit tax is part of the process to secure and sustain financial gains.
Consider How You Will Limit Your Tax Liability
Windfalls are considered income, and where there is income there is tax. Not only are you likely to incur federal and state income taxes, but also capital gains taxes and/or estate taxes on your money. Of course, this means that a significant portion of your windfall will be going right to Uncle Sam. More often than not, how you receive the windfall will also directly affect your after-tax, take-home amount.
Will you take a lump sum or spread receipt of the funds out over time? Will you inherit assets in kind or liquidate them and receive cash? It’s imperative to strategize with your CPA and financial advisor before making any moves to ultimately retain as much of your windfall as you can. Understanding windfall profits tax and how it affects your finances is crucial.
Eliminate Debts
Once you’ve decided how best to accept your windfall from a tax-planning perspective, you can start using funds to improve your financial situation. First and foremost, fast-track your debt repayment. Eliminate these pesky drags on your investment potential in order to free up cash flow and start to invest. Handling your windfall wisely can help you avoid unnecessary windfall tax implications.
Decide on a Spending Limit
Don’t overestimate your spending power and always be sure to keep money management high on the priority list. Spending limits, budgeting, and tracking are just as important for high-net-worth individuals as they are for those who live paycheck to paycheck. The only way you can be sure to keep your money is to know how much you are spending and where it is actually going. By managing your spending, you also manage the potential impact of windfall taxes.
Fill Your Emergency Fund
Once you have determined a safe spending rate, you’ll be able to estimate the three to six months’ worth of expenses you’ll need to have in your emergency fund. You never know when you could get laid off, need to replace the roof on your home, or pay for an unexpected medical emergency. Having a robust emergency fund allows you to handle these sudden events as they transpire without liquidating assets. Preparing for emergencies can mitigate the need to withdraw large sums and avoid windfall gains taxes.
Assess Your Portfolio’s Investment Objectives and Retirement Plan
Before a windfall, your portfolio’s primary objective may have been to grow your wealth to fund your retirement and leave a legacy. But with a sudden influx of assets, your situation is no longer the same. This is an appropriate time to consult with your financial professional to discuss any new objectives if they have changed. Your retirement plan will likely go hand in hand with the way you’re investing your funds. And of course, where and how you save for retirement will depend largely on your available resources.
It is likely you will begin by funding your 401(k) or IRA up to the maximum contribution amounts and dispersing the remainder of your savings amongst other tax-deferred and taxable accounts from where you will pool your retirement paycheck. Knowing what is a windfall tax and how it applies to your new assets will help you plan effectively.
Fund Life and Career Goals
Once you’ve decided how you will handle your tax liability, paid down or eliminated major debts, and formulated a long-term plan for your wealth, you can start to decide how you will fund other life and career goals. Is there an ongoing education or professional development class or conference you’d like to attend? Or perhaps you’d like to pay for your child’s or grandchild’s college education and save with a 529 plan.
Aligning your spending power with your life goals can be extremely empowering and rewarding. Proper planning ensures you make the most of your windfall gains.
Making the Most of Your Windfall
When you receive a large sum of money, your life can change in many profound ways. Be sure to take the time to identify the financial and life goals that are important to you; then, work with a financial professional to position your newfound wealth to help you reach them. By understanding windfall taxes and working to minimize their impact, you can preserve your windfall and use it to achieve your long-term objectives.
At Uncommon Cents investing, we specialize in helping individuals and families with all their retirement planning and wealth management needs. We invite you to take a look around our site and get to know us. If you like what you see, feel free to schedule a call on our calendar to get your questions answered or concerns addressed. Thanks for stopping by! We look forward to getting to know you.
