Make the Most of Your Sudden Wealth

For many of us, the first things that come to mind when we hear the words “financial windfall” or “sudden wealth” are winning the lottery or hitting the jackpot. But a surprise payday isn’t always a one-in-a-million game of chance. A financial windfall can also come from an inheritance, a legal settlement, equity compensation, or proceeds from the sale of a business, real estate or other valuable asset. 

Unfortunately, receiving a windfall isn’t a guarantee for long-term wealth. According to an Ohio State University survey of more than 2,000 high-net-worth families, 70 percent of families lost control of their assets in the first generation following wealth transfer. Likewise, Sports Illustrated once estimated that 78 percent of NFL players file for bankruptcy or experience financial stress within two years of retirement.

If you are lucky enough to be the recipient of a financial windfall, here are five strategies for keeping it:

1. Take a cooling-off period. Often, people view a windfall as “found money” and treat it differently than money they’ve worked to earn. Take some time after receiving a windfall and think about what you really want to do with it. Don’t quit your job, buy a Ferrari or give money away to friends and family members. People often underestimate how much money they will need to replace their current income, or how much they will need to support the retirement they envision. Avoid taking excessive risks. Often, people who receive windfalls become targets for people seeking funding for “surefire” investments or startup businesses. During this cooling-off period, you might want to keep your assets in a money market fund or other liquid investment. You should also think about creating a comprehensive financial plan that reflects your new circumstances, provides you with a roadmap for preserving your new wealth, and helps integrate your windfall into your overall finances.
2. Don’t forget about taxes. Some windfalls are tax-free, but inheritances may be subject to estate tax at both the federal and state levels, depending on where you live. Inheritances are not considered income and are generally not subject to income tax. However, there are a few exceptions. If you’re inheriting an IRA, any withdrawal you take is taxable at your personal income tax rate. If you’re inheriting stocks, bonds, real estate or other assets, you pay income tax on any dividends or interest you receive. You also pay capital gains tax if you sell the assets at a profit.
3. Pay off high-interest debt. Consider paying off any debt with an interest rate of eight percent or higher, such as credit balances, personal loans or even your children’s student loans. However, paying off a mortgage may or may not be a good idea since mortgage interest is tax-deductible. 
4. Create an emergency cash reserve. Your reserve should cover three to six months of living expenses, just in case someone loses their job or unforeseen expenses arise. You can keep these funds in a money market fund or any investment that you can convert to cash easily if you need it.
5. Assemble a financial team. If you’re not accustomed to dealing with a large amount of money, consider putting together a group of advisors who can help you make the most of your windfall. Typically, your team should include a financial advisor, an accountant, an estate attorney, a tax attorney and an insurance professional. A windfall is an opportunity to take a big step toward your reaching your goals—working with an experienced team that has your best interests in mind can help you preserve your newfound wealth. PM

Cathy Butler is a financial advisor at Morgan Stanley Smith Barney LLC in Peoria. She can be reached at cathy.butler@morganstanley.com or (309) 671-2873. For more information, visit fa.morganstanley.com/ccg.