Coming Into Money: How to Manage an Inheritance or Windfall
Inheriting money. Receiving a settlement. Earning a work bonus. Winning the lottery. These events can substantially impact your financial life, so it’s important to create a plan for your future before you start spending.
Key Takeaways
Sudden financial windfalls require careful planning to avoid impulsive spending and ensure long-term benefits.
Seeking advice from financial advisors, tax professionals and estate attorneys can help in making informed decisions.
Properly managing unexpected wealth and avoiding pitfalls can help improve your financial future.
For many people, a sudden influx of money can be overwhelming. It can be tempting to start spending it or follow the first advice offered by a friend or family member.
If you find yourself in this situation, you'll likely have to make some big decisions and navigate potential pitfalls. How well you manage can make a real difference in your long-term financial success.
Ask the Experts
Depending on the amount and source of the money, you could benefit from the guidance of a financial advisor, tax professional or estate attorney—or all three. These experts can help you navigate the rules and considerations related to the type of windfall you’ve received. They can also help you get started on your plans for the future.
How Do You Invest a Windfall or Inheritance Money?
Even if you have a specific purpose for the extra money, you may wish to work it into an existing financial plan.
1. Review Your Financial Picture
What did your finances look like before your windfall, and how does the new money affect your goals for the future?
Look at your current savings and investments, as well as your liabilities—student loans, mortgages and other debt. When coming into money, it’s a good idea to prioritize paying down debt and building an emergency account before you start spending and investing.
2. Identify Your Financial Goals
What (or whom) are you investing for? Investing wisely is key to maximizing the benefits of a windfall.
Define your goals. Do your plans include buying a home, funding a child’s education, traveling, planning for a secure retirement, leaving a legacy—or all of the above?
Set a time frame. Different goals usually require different timelines and strategies.
Add it up. Estimate how much you might need for each goal. You can use our Future Value Calculator to analyze various time and return scenarios to see what it might take to reach your ideal amount.
3. Understand Your Short-Term and Long-Term Needs
You may decide to spend some of your windfall right away or in the near future. Immediate goals might require a lower-risk investment to avoid near-term losses. Longer-term goals might need the growth and inflation-hedging potential of a higher-risk investment.
Evaluating your risk tolerance for various goals can help you as you’re determining how to invest.
4. Build a Diversified Investment Portfolio
Diversification, that is, spreading investments across different types of assets, can help you weather various market conditions over variable time frames.
Diversified portfolios are generally based on your time frame and tolerance for risk, and they’re generally comprised of a mix of three basic asset types: stocks, bonds and cash equivalents.
Stocks generally drive long-term growth. They’re usually the most aggressive element in a portfolio and carry more risk.
Bonds are a lower-risk asset. Bonds are usually considered less volatile than stocks. They may also provide income, which can be a buffer against less-predictable assets.
Cash equivalents offer the potential for stability. Money markets, certificates of deposit (CDs) and other short-term investments don’t offer much growth potential, but they can offer liquidity and lower risk.
Each of these asset types can also be split into more specialized categories, which can help you take advantage of different areas of the investment markets.
Should You Invest the Entire Amount Right Now?
Depending on the amount of your inheritance or windfall, you’ll need to consider your options.
Some choose to keep the money in a lower-risk vehicle and gradually add to their investments. Others may choose to wait for the “best” time to invest—either at a perceived market low or when they think the market may increase. But market timing requires a lot of luck and isn’t the most prudent long-term strategy.
Investing the money all at once might seem risky, but it can help ensure you’re putting it toward your future rather than spending it today. Even if current market conditions aren’t favorable, being invested can still help you take advantage of potential growth from a future market recovery.
Understand Taxes on Inheritance and Financial Windfalls
As you decide how to spend or invest your money, you’ll also need to understand how it will be taxed. A tax advisor can walk you through the tax rules for various types of windfalls.
Inheritance
If your windfall is an inheritance, remember that certain taxes may take a bite out of your proceeds—in certain cases. It depends on the type of asset you inherit and where you live.
Estate taxes are generally taken out of the decedent’s estate before the assets can be distributed to the heirs. Inheritance taxes, applicable in certain states, will apply to the assets that are distributed to the heirs.
Surviving spouses may qualify for preferred treatment when inheriting retirement plans. In addition to preferred rates for spouses, children of the deceased often are taxed at lower inheritance tax rates than other heirs. Be sure to check the laws in your state of residence with an estate planning attorney.
Spouses can roll an inherited IRA directly into their existing IRA. Other beneficiaries must open a separate Beneficiary IRA account.
For non-spouse beneficiaries, IRS rules require that inherited IRA assets be distributed 10 years from the year the person died. Required minimum distributions (RMDs) must be taken out on a yearly basis. Additionally, distributions from a Beneficiary IRA are taxed as normal income, an important consideration when determining how and when to use the money.
Settlements
In general, proceeds from lawsuits, settlements and awards are excluded from taxable income. But depending on the type of judgment, the awards may be taxable to the recipient. Insurance or lawsuit settlements for damages (other than punitive damages) are typically not taxed because they are not considered income.
Also note that the insurance company or medical provider may put a lien on your settlement money to be reimbursed for what they may have already paid on your claim.
Work Bonus
A bonus from your job might be another source of additional compensation. Bonuses are considered supplemental income, and the IRS withholding rate is 22%. Depending on the amount you expect, you may want to proactively work with your financial and tax professionals to avoid possible underpayment tax penalties and interest if you are in a higher marginal tax bracket.
Lottery Winnings
If you've struck it rich in a lottery, your tax hit could be substantial. If you receive a lump-sum payment (not available in all states), the IRS withholds 24% of your winnings right off the top, plus you may owe state and local taxes. Then you may owe income tax when you file your taxes, and your winnings could push you into the higher federal income tax brackets (up to 37%).
If you receive your payments over time rather than in a lump sum, the IRS withholds federal income tax from each payment you receive. You also may have to pay additional income taxes when you file your return, depending on your marginal tax bracket. Again, you may want to be proactive to avoid underpaying your taxes and being subject to penalties and interest.
Tax Refund
A tax refund may also be considered a type of windfall. It might be smaller than other sums discussed in this article, but you can still follow the same basic framework when deciding what to do with the money.
Receiving a lump-sum distribution from your employer's retirement plan when you change jobs or retire might feel like a financial windfall. But taxes and penalties could greatly affect the amount you receive.
If the retirement assets are not directly rolled over to another employer plan or IRA, 20% of the amount distributed to you will be withheld for federal income taxes. State income tax withholding also may apply. Plus, you could owe an additional 10% penalty for early withdrawal if you don't meet minimum age requirements.
Avoid Potential Pitfalls of Sudden Wealth
A sudden influx of money can put you at risk of fraud and scams, so you’ll want to take steps to protect yourself. You may wish to keep the information private to avoid becoming a target of scammers or others who take an interest in your new wealth.
It’s also essential to maintain financial discipline. Sticking with a budget (and resisting impulsive spending) and maintaining a disciplined investment plan will make a difference in your long-term financial success.
Additionally, be sure to stay on top of your immediate and future tax obligations. Penalties and interest can add up.
Plan Your Own Legacy
Whether you’ve inherited money or you’re planning on leaving a legacy, family financial discussions can help reduce disagreements, stress and confusion.
If you want your windfall to benefit future generations, you’ll need a thoughtful estate plan. Documenting your plan now will help ensure that your wishes are carried out and your money will go to the intended recipients.
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IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
This information is for educational purposes only and is not intended as a personalized recommendation or fiduciary advice. There are different options available for your estate planning. You should consider all options before making a decision.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.