Managing a windfall

From Bogleheads
Revision as of 19:14, 5 September 2012 by Blbarnitz (talk | contribs) (minor wordsmithing)
Jump to navigation Jump to search

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 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

  • 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]

Other common sources of receiving large lump sums: [3]

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

Managing a windfall

Take your time

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, [4] 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 1] 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;
  • 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

  • Paying down debt
  • Retirement
  • Charity

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. Coming Into Money: How to Manage a Windfall, American Century Investments

Notes

  1. 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 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

External links