Ever have that daydream about what you would do if you won the lottery? Maybe you’d go on vacation or maybe you’d buy that seven-bedroom mansion you’ve been ogling on Zillow. At one point or another, we’ve probably all thought about what we’d do if a large sum of money just appeared in our bank accounts. But what if it actually does happen?
Whether you get a large stimulus check, a big tax refund, a bonus at work, won the lottery or hit it big at the casino, it’s really easy to want to spend that money quickly. That expensive car or a bungalow over the water in Bora Bora starts to seem within reach.
But, slow down for a moment. Spending all of your newfound wealth right away may feel great for a few minutes, but if you take time to create a plan for the money, you could potentially turn this small lump sum into long-term wealth. Here are a few tips about how to allocate a windfall if you receive one.
Evaluate your emergency fund
You need a strong emergency fund in case a less-than-ideal situation happens, like losing your job or needing a costly car repair. We recommend having an emergency fund of about six months worth of necessary expenses. This way, you’ll be able to cover any unexpected future costs without needing to take out a personal loan, a new credit card, or borrowing money from family or friends.
To figure out how much you need, add up all of your essential monthly expenses, and multiply it by six. For example, if you’re spending about $2,500 per month on necessities, you should aim to have around $15,000 in your emergency fund.
Automatically contributing a certain amount of money from your paycheck each month is a great way to build up this safety net, but making a large contribution with your new windfall can get you closer to that six-month goal much faster. Once you hit your target amount, you’ll have the peace of mind that you’ll be okay if life decides to throw you an unexpected, expensive surprise and you can start saving for more fun things you might want.
Pay down your debt
If you have debt, your new windfall could make a big dent in it. To determine which debt you should pay off first, look at which loan has the highest interest rate, and start there. Review all of your credit cards, student loans and home and auto loans. Depending on the amount of your new money and the amount of outstanding debt, you may not be able to pay off the whole thing right away, but by putting a large chunk of your windfall toward the loan, you’ll make tons of progress toward paying down this debt quickly and be able to shorten your repayment terms.
Save for retirement
If you’re already set with an emergency fund and have paid down your debts, start looking toward your retirement. While you can’t just add a large amount of money to your 401(k), you can open up a Traditional IRA or Roth IRA and make contributions to that. Currently, total annual contributions to a Roth and Traditional IRA can’t exceed $6,000 if you’re under age 50 and $7,000 if you’re 50 or older.
What’s the difference between each type of IRA? With a Roth IRA, you contribute after-tax money. That money grows tax-free, and then you can make a tax-free withdrawal after age 59½. A Roth is a good option for people who think they will be in a higher tax bracket when it’s time to withdraw. With a traditional IRA, you’ll make pre-tax contributions and then that money is taxed when you withdraw at 59½. These are good options for those who think they’ll be in a similar or lower tax bracket when they withdraw.
By working toward maxing out your contributions this year, you’ll set your future self up for success. The portion of your windfall that you contribute to these accounts may seem like a lot of money, but think about how much more it will grow over the next 10, 20 or 30 years and how happy you’ll be to have those savings when you’re older.
Invest in the stock market
Retirement accounts aren’t your only investment option. If you’ve maxed yours out but still want to play the stock market, start investing. A good option for beginners is micro-investing. Apps like Acorns, Stash, Robinhood and Betterment help you easily invest with little effort. Some of these apps, like Betterment, even have financial experts you can talk to about your investment strategy.
If you’d rather work with a real person, search for a fee-only financial planner in your area. Fee-only financial planners are compensated by you, the client, rather than by a commission based on the financial products they sell. Because fee-only financial advisors get paid by their clients, they put your interest above their own. A financial planner can help you figure out which investments work well for your budget and long-term goals.
Buy yourself something small
We know it’s super tempting to spend your new cash on that expensive wishlist item you’ve been saving up for (like that new entertainment system), but don’t press “Buy Now” just yet. Keep saving up for that big purchase in a “dream fund,” but don’t totally restrict yourself. Have a little bit of fun with this new money. Spend a small amount of the windfall (10-20%) on something great for yourself. Treating yourself a bit will make the saving feel more worth it.
Donate to a cause you care about
If you’re looking to do some good with the money you recently received, consider finding a charitable cause you care about. Donating to a charity might give you some benefits come tax time too because some charitable contributions might be tax-deductible. To determine which types of organizations are eligible for charitable contribution deductions, check out the IRS website.
Don’t forget about taxes
One more thing: Before doing anything with this new, large amount of money, we recommend talking with a tax professional to figure out how this might affect you next April. Cash gifts under $15,000 don’t affect your taxes, but gambling or lottery winnings will be counted as income, meaning you’ll have to pay taxes on them. Talking with a tax professional can help you ensure you set enough money aside to cover your tax bill next spring.
What’s your plan for a windfall?
Getting an unexpectedly large sum of money is exciting, but having a plan for what to do with it can be even better. By using the money smartly, you can ensure that you’re benefiting from this windfall for years to come rather than spending it all at once without thinking (but we won’t judge if you take yourself to a nice dinner while you’re figuring out what to do).