I read once that the typical windfall is spent within 18 months. No matter how big the inheritance, bonus, tax refund, lottery win, or lawsuit settlement, people think they're richer than they really are and the money is soon gone.
I thought I was smarter than that.
Then I received an $80,000 bequest from a relative when I was 30. A big chunk, $50,000, became the down payment on my first home. The rest? I have no idea. It was spent in dribs and drabs, here and there, on this and that. What I do know is that in a couple of years, it was gone.
Financial planners will tell you there's a much better way to handle windfalls, and that's to have a written plan that outlines what you'll do with each dollar. Here’s how to do just that.
Park It Somewhere Safe
While formulating your plan, your money should be securely stowed in FDIC-insured savings accounts. Don't tie it up in any investment that isn't safe and liquid until you know what you're doing with the money. If the windfall is bigger than $250,000, the typical FDIC coverage limit, you may want to use more than one bank.
If the money is an inheritance or gift and you're married, think about putting it into accounts in your name only. These windfalls can be considered separate property if they're not mixed in with jointly held funds.
Many windfalls are considered taxable income, so you could face an unpleasant surprise April 15. Even bequests, which aren't subject to federal taxes, can trigger a tax bill in the handful of states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) that have inheritances taxes. A tax pro can help you figure out how your windfall will be treated and estimate how much of it you may need to set aside to cover the extra tax bill.
Understand Your Brain
Money is fungible, which means it's all pretty much the same regardless of where you got it. But that's not how our brains see it. Thanks to a quirk behavioral scientists call "mental accounting," we treat different pots of money differently. If we think of a windfall as income, for example, we're more likely to spend it. If we think of it as wealth, though, we're more likely to save it. Here’s more on how to trick your brain and build your wealth.
Where Do You Need the Most Help?
Are you behind on retirement savings? Do you have credit card or other toxic debt? Is your emergency fund pathetic? If you answer yes to any of those questions, then the bulk of your windfall should go toward fixing the deficit. If you answered yes more than once, you may have to identify the most pressing need.
Financial planners typically recommend that you first make sure to contribute enough to your workplace retirement plan to get the full company match, then pay off the credit cards, then build up your emergency fund. If you're unsure how to proceed, spend a few hundred bucks on a session with a fee-only financial planner — one who is compensated only by the fees you pay, as opposed to working on commission. You can get referrals to fee-only planners from Garrett Planning Network, the XY Planning Network, or the National Association of Personal Financial Advisors.
Decide What You'll Share
Giving away money makes us happier than spending it, behavioral scientists have found. Whether you're contributing to a charity, boosting a relative's college fund, or helping a friend in need, you can feel good about your generosity as long as you set reasonable limits. (Excessive handouts to family and friends are among the reasons lottery winners go broke.)
If your windfall is large or public, people will come out of the woodwork asking or even demanding a share. This is another good reason to hire a planner: You can funnel all the "asks" through him or her.
Splurge a Little
Life isn't all about delayed gratification (or at least it shouldn't be). Carve out some of your windfall — say, 10 percent or so — for something fun. But take another cue from behavioral science and think about buying experiences rather than more stuff. Research shows we get used to new possessions really quickly (something known by the sinister-sounding term “the hedonic treadmill”), but experiences give us longer-lasting pleasure.
If you do buy stuff, make it "experiential goods" — purchases that support pleasurable activities, such as a gaming system you can play with friends, camping gear for trips with your family, or a musical instrument you can master, giving you a sense of accomplishment and competence. Either way, you'll be investing in your future happiness.
Liz Weston is an award-winning journalist and author of several money books, including the best-selling Your Credit Score. She writes about personal finance at her site, AskLizWeston. You can like her on Facebook and follow her on Twitter.