Say you inherit, win, or earn $3,000, $30,000, or even $300,000. Lucky you.
What should you do with a windfall of money?
You may be inclined to spend it; to buy a new ride or take the trip you’ve been longing for. The urge to splurge is normal; people are more likely to spend unanticipated money (i.e., a windfall) than anticipated money, like wages (Arkes, Joyner, et. al., 1994). Unfortunately, spending your windfall—or at least all of it—probably isn’t the best move.
Here’s a prioritized list of arguably the best ways to use a windfall. Your individual situation may dictate deviating from this list slightly, but this is solid foundation for planning how to use unexpected money. (Note: You may decide to split your windfall among a few of these goals; that’s fine.)
1. Account for Taxes
Most likely, your windfall is taxable. Before you spend a dime, figure out what taxes (if any) have been withheld, and if it was enough. If the windfall is especially large (say, equal to or more than your regular annual income), it would be wise to hire a tax professional to help you minimize your tax liability.
2. Pay Down High Interest Debt
Once you are confident that Uncle Sam is paid-in-full, put high-interest credit card debt in your crosshairs. If you have debt and your windfall can repay it in one chunk, do it. Be sure to have plan for handling your credit cards after the debts are paid. Can you resist using them to dig a hole again? If not, get rid of them.
3. Check On Your Rainy Day Fund
If you don’t have debt or have windfall money left over after paying debts, it’s a good time to give your emergency fund a check-up. As a bare minimum, do you have at least $1,000 in a savings account set aside for emergencies? What about between three and six month’s living expenses? If not, use your windfall to pad this ever-important account. Don’t worry too much about the interest rate you are getting. This money is not an investment, it’s your safety net.
4. Max Out a Roth IRA
Next, consider funding a Roth IRA up to the annual maximum allowed contributions. A Roth IRA grows tax-free for retirement; it’s the absolute best way to make today’s windfall turn into tomorrow’s nest egg. You can contribute up to $5,000 to a Roth if your income falls below defined limits. You have until April 15 each year to contribute to a prior tax year’s Roth IRA. For more, read Why You Need a Roth IRA.
If you have money left over and have a 401(k) or 403(b) plan at work, you may also want to increase your contributions to that account, which are tax-deferred. The money going to your 401(k) comes out of your paycheck, but you can use your windfall to supplement your earnings.
The next step is to invest remaining funds as you see fit. You may choose to open an account with an online broker and pick up some ETFs or no-load mutual funds, lend money to others using a social lending network, or use the money to see a new business venture. Whatever you do, your goal should be to make the money work for you today so it can provide for you tomorrow.
5b. Pay Down Other Debts
Some people would rather be completely debt-free before using extra money for anything else. Personally, I would rather invest money in the stock market before repaying student loans and mortgages with interest rates under six percent, but I understand why some people would want to get rid of these debts first, no questions asked. If your goal is to be 100 percent debt-free as soon as possible, then by all means, pay down student loan or mortgage debt now.
6. Buy Yourself Something
Have some fund, spend a little. Life is short, and it’s stupid to be young, broke and miserable just to grow old and rich! (Just don’t blow all of your windfall redneck-lotto-winner-style.)