Difference between revisions of "Managing a windfall"

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* [http://www.settlementadvisor.com/Misc_Resources/Windfall%20Nefe.pdf Financial Psychology and Lifechanging Events] is a good general guide.
 
* [http://www.settlementadvisor.com/Misc_Resources/Windfall%20Nefe.pdf Financial Psychology and Lifechanging Events] is a good general guide.
 
* [http://www4.gsb.columbia.edu/filemgr?file_id=7217585 Entrepreneurs: Life after Exit] examines issues involved in selling businesses.</ref>  
 
* [http://www4.gsb.columbia.edu/filemgr?file_id=7217585 Entrepreneurs: Life after Exit] examines issues involved in selling businesses.</ref>  
* Begin to think about long term goals and how they might be attained. Whether or not you are inclined to "do-it-yourself", this period is a good time to read some [[Books: Recommendations and Reviews|recommended books]] on personal investing. This can help you know what to look for in an adviser or advisers.
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* Begin to think about long term goals and how they might be attained. Whether or not you are inclined to "do-it-yourself", this period is a good time to read some [[Books: Recommendations and Reviews|recommended books]] on personal investing. This can help you know what to look for in an adviser or advisers. <ref group="footnotes"> Should you decide to use an adviser, the authors of ''The Bogleheads' Guide to Investing'' (Chapter 16, p.193: Wiley. ISBN 978-0471730330) recommend choosing an adviser who has earned a CFA (Chartered Financial Analyst) or a CFP (Chartered Financial Planner) designation; use a fee-only payment arrangement;  and advocate an index fund investing approach.</ref>
 
* Begin thinking about creating a new financial plan that incorporates the windfall.
 
* Begin thinking about creating a new financial plan that incorporates the windfall.
  
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* Calculate any taxes due on the windfall;
 
* Calculate any taxes due on the windfall;
 
* Recommend any additional types of insurance you may need, or what current types of insurance you hold may no longer be needed;
 
* Recommend any additional types of insurance you may need, or what current types of insurance you hold may no longer be needed;
* Determine whether you need to enlist an estate planning attorney;
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* Determine whether you need to enlist an estate planning attorney; <ref group="footnotes"> The authors of ''The Bogleheads' Guide to Investing'' (Chapter 15, p.185: Wiley. ISBN 978-0471730330) recommend [http://www.martindale.com/ Martindale & Hubble] for checking out the credentials of an attorney. </ref>
 
* Calculate whether it is better to receive a lump sum or annuity stream of payments from a settlement, lottery winning, or retirement package. <ref name="Guide"/>
 
* Calculate whether it is better to receive a lump sum or annuity stream of payments from a settlement, lottery winning, or retirement package. <ref name="Guide"/>
  

Revision as of 06:48, 8 September 2012

A windfall, in personal finance, is defined as an amount of money that a person gets unexpectedly. Windfalls can range in magnitude from small additions to an individual's wealth to a significant increase in fortune. Since a large windfall almost invariably means huge changes in a recipient's life, psychological and emotional factors [footnotes 1] are often the most important factors determining outcomes. The National Endowment for Financial Education advises windfall recipients to take the following course of action. [1]

Do nothing rash. Set aside one year's living expenses and place the rest of the windfall into low risk investments (fdic insured accounts, money market funds, treasury bills) for one year. As it may take as long as five years for the windfall recipient to adjust to a new life, this pause provides a chance for emotions to cool, helps avoid impulsive behavior, and, if warranted, allows the recipient time to put together a team of professional advisers.

Common sources of windfalls

Windfalls come in many forms. Here are some common types:

  • Legal settlements : Settlements include personal injury settlements, settlements involving workers compensation and settlements of employment discrimination. Settlements are taken as either a lump sum or, alternately, as a structured settlement of annuity payments.
  • Inheritances: These can often involve retirement accounts and assets held in trust.
  • Gifts: These can range from annual gift exclusions up to the lifetime estate taxation credit limit.
  • Lottery winnings: Taken as a series of payments; or as the sales value of payments exchanged for a lump sum.
  • Insurance settlements: These can be in the form of death benefits received as either a lump sum or annuity; as pre-death cash surrender values; or as life settlements, the sale of a life insurance policy by the owner to a third party in exchange for a lump sum.
  • Retirement lump sums: Usually taken in lieu of a lifetime series of annuity payments
  • Sudden increases in income: These can come in the form of bonus payments; stock options; or cashing shares in an IPO. [2]

While not being external sources of new wealth, other common sources of receiving large lump sums include the following: [3]

  • A real estate sale
  • The sale of a business
  • Widowhood and divorce

Sales of businesses and real estate involve the conversion of an illiquid asset into large sums of fungible cash. Death and divorce not only cause dislocation and trauma, but often result in suddenly thrusting an individual who has had little or no interest in investing, and having little or no investment experience, into the position of managing family wealth.

Managing a windfall

Finance authorities are in agreement that avoiding immediate impulse decisions, especially in regard to large life changing windfalls, is a key to prudent management of the situation. Common errors of commission include buying extravagantly priced automobiles or engaging in other expensive consumption spending; feeling overconfident about one's business or investing acumen, resulting in jumping into new high risk investments (such as hedge funds) or as an "angel" investor in start-up companies; falling prey to overcomplicated estate and investment management schemes (be on the alert for people who may be trying to exploit you or take advantage of your new wealth. It’s important to recognize that you can be a target for all kinds of financial schemes); and finally, by being too generous to family, friends, and charities. [4] To avoid such errors, the following management techniques are recommended.

Take your time

Finance authorities are in agreement that avoiding immediate impulse decisions is key to prudent management of the windfall situation. Among the recommendations for this period are the following:

  • Set aside six months to one year's income requirements. Place the remaining windfall assets in secure low-risk savings vehicles, such as fdic guaranteed bank accounts, money market funds, or treasury bills.
  • Use this period of time to begin resolving emotional, family, and social issues. [footnotes 2]
  • Begin to think about long term goals and how they might be attained. Whether or not you are inclined to "do-it-yourself", this period is a good time to read some recommended books on personal investing. This can help you know what to look for in an adviser or advisers. [footnotes 3]
  • Begin thinking about creating a new financial plan that incorporates the windfall.

Determine your tax situation

A windfall often involves tax obligations. Estimated taxes may need to be filed. Complex tax issues may surround distributions from retirement plans, inheritances, and lottery winnings, [5] as well as the exercise of stock options. If professional tax assistance is warranted, enlisting the help of a Certified Public Accountant (CPA) who does not sell investment products may be a prudent step. [3]

A CPA may have a Personal Finance Specialist (PFS) designation. [footnotes 4] A good CPA can do the following:

  • Calculate any taxes due on the windfall;
  • Recommend any additional types of insurance you may need, or what current types of insurance you hold may no longer be needed;
  • Determine whether you need to enlist an estate planning attorney; [footnotes 5]
  • Calculate whether it is better to receive a lump sum or annuity stream of payments from a settlement, lottery winning, or retirement package. [3]

Formulate a plan

A financial plan [footnotes 6] is a long-term process of managing your finances so you can achieve your goals and dreams, while at the same time negotiating the financial barriers that inevitably arise in every stage of life.[6]

The steps necessary for implementing the inclusion of a windfall into a financial plan will be affected by the the windfall recipient's age and investment knowledge as well as the size of the windfall relative to the recipient's current wealth. An individual with an established financial plan and investment portfolio, upon receiving, for example, a profit-sharing bonus, might simply invest the bonus into the investment portfolio. For life changing windfalls, and situations involving inexperienced investors, the step by step process of establishing a financial plan can help the individual to rationally meet goals.

See also

References

  1. Financial Psychology and Lifechanging Events, NEFE
  2. CFP Study Guide investopedia
  3. 3.0 3.1 3.2 Larimore, Lindauer, and LeBoeuf (2006). The Bogleheads' Guide to Investing. Chapter 15: Wiley. ISBN 978-0471730330.
  4. Financial Planning for a Windfall in Wealth: Lotteries, Stock Options, Inheritances and Other Surprises, Stephen L. Nelson, CPA, PLLC.
  5. Coming Into Money: How to Manage a Windfall, American Century Investments
  6. What is Financial Planning?, by the Financial Planning Association

Notes

  1. A wide range of responses can accompany a financial windfall. Persons who have experienced financial windfalls have shared that they’ve experienced some or many of the following emotions as they adjusted to their new circumstances.
    Emotional reactions to windfalls Source: Financial Psychology and Lifechanging Events, NEFE
    • Elation
    • Fear of loss of money
    • Fear of a change in relationships with others
    • Anxiety
    • Paralysis
    • Inability to see the money as a gift or an advantage
    • Not knowing what to do with the money
    • Depression
    • Resistance
    • Anger
    • Grief
    • Distrust
    • Numbness
    • Isolation
    • Feelings of unworthiness
    • Resentment
    • Lack of confidence
    • Guilt
    • Desire to give it all away
    • Intimidated
    • Lack of identify
    • Sense of loss
  2. The emotional and social issues surrounding windfalls are explored in greater detail in the following links:
  3. Should you decide to use an adviser, the authors of The Bogleheads' Guide to Investing (Chapter 16, p.193: Wiley. ISBN 978-0471730330) recommend choosing an adviser who has earned a CFA (Chartered Financial Analyst) or a CFP (Chartered Financial Planner) designation; use a fee-only payment arrangement; and advocate an index fund investing approach.
  4. To avoid conflicts of interest, it is advisable to select a CPA (PFS} who does not sell financial products and does not accept compensation from the other professionals the CPA may recommend. The American Institute of Certified Public Accountants has a website where one can search for a CPA (PFS) in your locale: Find a CPA
  5. The authors of The Bogleheads' Guide to Investing (Chapter 15, p.185: Wiley. ISBN 978-0471730330) recommend Martindale & Hubble for checking out the credentials of an attorney.
  6. A sound financial plan incorporates these steps: Source :What is Financial Planning?, by the Financial Planning Association
    1. Establish Goals
    2. Gather Data
    3. Analyze & Evaluate Your Financial Status
    4. Develop a Plan
    5. Implement the Plan
    6. Monitor the Plan & Make Necessary Adjustments
    A list of things to do:
    1. Create a realistic budget with adequate insurance
    2. Plan for paying off existing credit card debts and other loans
    3. Plan for saving to meet your goals
      1. The time horizon will define your investing strategy (dream home, retirement, college)
      2. Understand your need, willingness and ability to take investment risk
      3. Write an Investment Policy Statement (IPS) or Investment plan
    4. Create an estate plan

External links