Managing a financial windfall

What are the odds that you or someone close to you will enjoy a financial windfall during your lifetime? If you’re counting on winning a lottery, the odds are ridiculously bad. For example, the chance that you could draw the correct six numbers out of a set of 49 in one of the big national lotteries is somewhere in the range of one in 14 million.

Of course, people do win lotteries, gamblers have lucky streaks, and legal actions often result in settlements. Much more likely, though, any windfall bestowed on you or your clients will be courtesy of an inheritance. Today there are approximately 10 million baby boomers approaching retirement, many of whom expect to partially fund that retirement through the inheritances they receive. Understanding how to effectively help clients manage this windfall, the emotional fallout and establishing a financial plan will become increasingly important to ensure their income lasts a lifetime.

Pause, then plan

The question then becomes: What would you do with no-strings, non-taxable windfall if you received one? The answer isn’t as simple as many of your clients might think. Managing the benefits of a financial windfall is really a three-part process, starting with a necessary psychological adjustment, then prioritizing how it will be dealt with, and ending with a sound, long-term financial plan. The goal is to place a financial windfall in the context of an individual’s life and finances, and plan wisely to ensure that it has a lasting positive impact on the person and his or her family.

The first priority when a windfall arrives is to take time to adjust to it. It’s perfectly normal to experience surprise, indeed, shock. And certainly in the case of an inheritance, there is an overlay of grief and mourning which can deeply affect a person’s actions and reactions. People who have won lotteries have often reported that they felt overwhelmed, in part by the sheer size of their good fortune, but also because of the newfound closeness, and demands, of relatives and newfound friends. Those who won legal settlements initially tend to feel enormous relief that the process is over rather than delight in newfound wealth.

Balancing pleasure with practicality

For all these reasons, it is wise to delay making decisions that may be driven by emotion rather than sound judgment. That doesn’t mean doing nothing, however. Individuals would be well advised to put the proceeds of the windfall into a secure investment – and here advisors can be helpful – that will preserve capital while maintaining liquidity. It also makes sense to initially balance pleasure and practicality. A small amount of the windfall should be set aside for personal enjoyment, fun money, but individuals should also be taking stock of their current financial situation by listing current expenses and needs as well as outstanding debts and commitments.

Taking a snapshot of your financial situation today is the necessary precursor to the kinds of decisions that have suddenly become possible. With a windfall, there are financial choices which a person may never have contemplated before. And at this point, the role of the financial advisor becomes far more important.

Setting priorities

There are obvious priorities when it comes to spending newfound cash, starting with the elimination of credit card and mortgage debt. Any debt, especially if it carries a high interest rate, should be paid down. Once the basics have been cleaned up, individuals can look ahead to potential uses for their new money. Many will want to buy new vehicles, renovate homes, move to bigger homes, or perhaps buy cottage properties. Vacations also loom large for people because previously unattainable travel options are now possible.

More serious choices focus on planning for a family’s future. If there are children, saving for their education using an RESP or other option is desirable. In many cases, people will wish to make gifts to close or extended family members.

Beyond the family, individuals may wish to donate to charities, itself a process that requires careful thought and study to choose causes that will resonate with donors and their preferences. More ambitious people may consider setting up a charitable foundation, a major undertaking that involves significant financial issues ranging from the way it’s funded to the tax implications of donations. These can be deducted against taxable income and in some cases the deductions can be carried forward up to five years. Professional advice is a must for anyone electing to establish a foundation.

Ultimately, people who have been fortunate enough to have a windfall require a long-term financial plan. They should have had one to begin with, but with the added weight of additional wealth, a plan becomes all the more essential. It would also be a good time to relay the foundation of estate planning with an updated will.

Windfalls come with a variety of complications, not the least of which are tax issues. When winners receive upfront, lump-sum payments, generally, they are tax free. But in the case of a prize which comes in the form of an annuity generally, income tax is payable on any interest that the annuity generates. Moreover, subsequent earnings generated by a windfall will be subject to the same tax rules as any other investment.

Advisors can help

Financial advisors can be enormously helpful in helping to deal with tax questions and to develop long-term plans that balance short-term needs against long-term expectations. Advisors can help their newly well-off clients balance their portfolios to ensure that tax-efficient products are held in non-registered accounts while the tax-inefficient products – primarily interest-bearing investments – are held in registered accounts.

If a client has recently acquired unexpected wealth, or has a windfall in the offing, tell them to sit back and take a deep breath. A windfall presents all kinds of opportunities, but it also imposes added responsibility that requires careful analysis and prudence. Advisors should be relied on to ensure that it brings a lasting benefit front for individuals and their families.