Wondering what to do with a windfall? Perhaps you have received an inheritance or experienced a liquidity event from company stock. Now you need to know how to use the proceeds to maximize the benefits for your family, and help achieve your lifestyle goals. Ultimately, how to invest a windfall will depend on a number of factors, including your risk tolerance, time horizon, and specific goals. However, there are a number of best practices and considerations to keep in mind as you begin the financial planning process.
The Tax Treatment of a Windfall
Windfalls can come in many forms so it is important to understand the exact details of yours. If you've received an inheritance, is it in cash? Stock? Property? Inheriting a retirement account like a traditional IRA is treated differently than other types of accounts for tax purposes. Although there are exceptions, life insurance proceeds received in a lump sum aren't typically taxable. Review our overview of how an inheritance may be taxed for more information.
If your windfall is from the sale of a business or proceeds from a large liquidation of stock (which typically happens after a trigger event such as an IPO, merger, or acquisition), it is equally important to understand the tax treatment of the funds. In these types of events, there usually isn't any automatic withholding, so it is important to work with your CPA or accountant to estimate the taxes due and make quarterly payments as necessary.
Once you have a better idea of the taxation of your windfall you can estimate the proceeds you'll have available after tax.
Identifying Your Investment Opportunities Through Financial Planning
For many of us, our lifestyle goals are not in short supply. The challenge then becomes prioritizing wants and needs to arrive at the best plan for you. Without developing a comprehensive financial model, it is very difficult to accurately evaluate multiple scenarios, trade-offs, and opportunity costs over the long term.
Sometimes investors are tempted to plow most of their liquid windfall proceeds into real estate or other personal property. However, as you consider the best uses of the sudden liquidity, remember the importance of diversifying your investments and the benefits of compounded investment returns over time.
When we develop a financial plan for our clients, we combine all the pieces of their financial and life situation to create one cohesive view. Using income, fixed expenses and other discretionary spending data, we are able to project clients’ cash flows.
Throughout the analysis, a windfall can be allocated to different 3 broad goal-based categories: spending, investing, and saving.
Think of spending as many different types of short-term cash outflows such as buying a home or other real property, large charitable contributions, or perhaps paying off debt. Investing is for longer term goals, at least five years away, and may include retirement or college planning. Saving is primarily used when current cash reserves are insufficient and properly funding an emergency fund is advisable.
Now recall the different types of windfalls discussed at the beginning of this article. Depending on the type of liquidity event you’ve experienced, the funds may not be available at once, or there can be limitations or a penalty for when and how the proceeds are used. Timing plays a key role in financial modeling, as does taxation.
Unless you have just won the lottery, your recent windfall is likely not enough to fully fund all of your goals. Through modeling, we can help you evaluate trade-offs within the assumptions of the plan. For example, assume your goals (in no particular order) are to: retire in 15 years, buy a 40' sailboat next year, and pay for 100% of your child's college education, beginning in 5 years.
The Monte Carlo projections reveal the windfall cash is insufficient to fully fund each of these goals, based on 500 simulations of possible market returns. However, the Monte Carlo projections did produce a satisfactory result if you retired in 17 years or planned to fund 75% of the costs of college. Instead of just "winging it," a financial model can help provide the information you need to make more deliberate financial decisions for you and your family.
To discuss how a financial plan may be able to help you maximize the benefits of a windfall, schedule a free consultation with an advisor today.