Whether expected or unexpected, life can take a turn when a wealth event leaves you with a lump sum of money. From selling real estate to receiving an inheritance, financial windfalls come in all shapes and sizes. And while an event like this can positively impact your financial situation, it can also feel overwhelming.
We’ll explore key financial planning considerations to ensure your long-term financial security after experiencing a sudden wealth event.
What is a Sudden Wealth Event?
The tactics below can apply to finding a forgotten $20 bill in your jacket pocket, or the year-end bonus or a raise at work. However, a “sudden wealth event” is usually described as a significant financial windfall or an increase to your net worth, where all of a sudden you are accountable for a substantially larger sum of money than you’ve ever managed before.
A sudden wealth event can show up in many ways, like:
- Sale of a business
- Sale of real estate
- Receiving an inheritance
- Stock options or equity compensation
- Proceeds from a lawsuit
- Winning the lottery
Regardless of where your financial windfall originates, it’s clear your financial situation has shifted. What appeared unattainable just a few months ago may now be achievable.
Assess What is Important to You
Before you dive into the financial details of what to do with your new wealth, you probably should start with revisiting your values and priorities. What is important to you in life regardless of how much money you have or don’t have.
You’ll want to maintain these values moving forward.
Considerations for Different Ways of Receiving Your New Wealth
A wealth event can be received in different ways.
Receiving Illiquid Assets
As part of your sudden wealth event, you may have received an illiquid asset. An illiquid asset cannot easily be easily or quickly converted to cash. For instance, perhaps you inherited a home from a family member.
Consider your approach to handling an illiquid asset and explore potential strategies for divestment and diversifying into other investments to better manage risk. Using the example of inheriting a home, you might contemplate the following options:
- Sell the property as quickly as possible, utilizing the cash proceeds to invest in a low-cost, globally diversified portfolio, aligning with your financial goals
- Keep the property for personal use as a vacation home for your family
- Rent out the property to generate ongoing income, accelerating progress toward your financial objectives
Receiving Liquid Assets
As part of your sudden wealth event, you may have received a more liquid, or easily convertible to cash, asset. These could include cash or cash equivalents themselves or a taxable brokerage account with stocks, bonds and other liquid investments, for instance.
When receiving cash or other liquid investments, you will need to assess your short-term needs or desires (more on that later). This will help you determine whether adequate funds are required immediately and how much you can invest or retain for future long-term growth.
NOTE: In the event of receiving non-cash assets as a gift or inheritance, it’s also critical to understand the cost basis of the assets in your possession and be aware of the potential future tax implications. In simple terms, the cost basis is the amount paid for an asset, but with gifts and inheritances, this will look different (discuss with a tax professional!).
Reevaluating Your Goals After a Sudden Wealth Event
Sudden changes in wealth also provide an opportunity to reassess your financial goals and explore new possibilities with the increased funds that may not have been achievable before.
Consider Paying Off Debts
You may have outstanding debts that should be part of the conversation as well after a financial windfall event.
A snapshot of your debts may lead to the following opportunities:
- Credit Cards: Focus on wiping out what it most commonly the most expensive debt to owe, giving priority to cards with higher interest rates
- Mortgage: Evaluate the benefits of paying it off in a lump sum, increasing monthly payments, or maintaining the current status
- Student Loans: Assess your repayment options and the impact of paying off your balances in a lump sum
- Auto Loans: Consider finally paying off that lingering car loan, especially if you’ve been contemplating it since retiring
NOTE: In the NewRetirement Planner, if you want to see how your plan changes through paying off debt early, you can model making lump-sum payments through My Plan > Money Flows > Transfers.
Boost Your Emergency Fund
Building a solid foundation for financial wellness begins with ensuring you have sufficient emergency savings.
You may have been lacking adequate emergency fund savings before the sudden wealth event. Using cash from the wealth event or turning some liquid investments into cash to boost your emergency fund can significantly improve your financial picture.
Assess Short-Term Spending Needs
You will want to determine if you have any upcoming cash needs.
For instance, do you need to make a plan to fund any income tax liability that may have resulted from the wealth event? Setting aside this cash for taxes will avoid any surprises and increased stress come tax time.
Also, you might have had a significant upcoming expense on the horizon. Whether saving for a car purchase or planning a kitchen remodel next year, the financial windfall now provides the opportunity to achieve these goals sooner.
Consider those short-term goals or large purchases you may have within the next 1-3 years, and allocate adequate cash from the windfall to cover these impending expenses.
NOTE: You can utilize the NewRetirement Planner to account for future one-time expenses as part of your financial plan. It’s important to note that one-time expenses are detailed in future dollars in the tool, so be sure to think through those expenses with that mindset.
Accounting for Additional Wants and Wishes
You may also have extra room in your annual spending plan for some of your wants and wishes that you weren’t entirely sure were possible before.
Do you want to travel more? Do you want to try the best restaurants in your city every month? Do you want to get a spa treatment every other week instead of every other month?
Revisiting your spending plan to make room for additional expenses with an increased cash flow can prove to be a valuable exercise.
Make use of the NewRetirement Planner Detailed Budgeter to look at your plan through a “Like to Spend” toggle where you can really dream (and what may now be a reality!) and enhance your wants and wishes in certain categories.
Investing for the Long-Term
Your financial goals may require investing for long-term growth.
Whenever you are investing any sum of money (let alone funds from a sudden wealth event), it’s essential to establish a clear goal. Establishing a specific goal guides your choice of investment account, fund types, and investment amount. For instance, investing for a new investment property in 4 years will likely require a different strategy than investing for your retirement in 15 years.
Revisiting your investment strategy and making any appropriate adjustments to your objectives, risk tolerance and time horizon is a worthwhile time commitment after a significant financial event.
Income Tax Planning Considerations After a Sudden Wealth Event
As is common with many financial life events, taxes are an important part of the equation as well.
Characterization of Taxes: Ordinary Income vs. Capital Gains
Various types of income are taxed differently under the U.S. tax system, with two primary distinctions between ordinary income and capital gains tax.
Ordinary income is any income taxed at your regular tax rate, also known as your marginal tax rate. Some sudden wealth events, like inherited traditional IRA RMDs, severance pay, and certain settlements, will experience this tax treatment. If so, consider the following:
- If tax isn’t withheld, reserve adequate cash to pay income tax, and make estimated payments, if necessary
- If you are on Medicare and the income increases your MAGI (Modified Adjusted Gross Income) above certain thresholds for the year (i.e. IRMAA or income-related monthly adjustment amount), you may become subject to Part B and Part D surcharges in two years
- If you have net investment income and the income increases your MAGI above $200,000 ($250,000 if MFJ), you may become subject to the 3.8% NIIT (Net Investment Income Tax)
Meanwhile, capital gains tax can apply when you sell a capital asset for more than you paid for it. Short-term capital gains result from sales of assets held for a year or less. These capital gains are taxed at your ordinary income tax rate. Long-term capital gains from sales of assets held for more than a year receive a more favorable tax rate. Long-term capital gains rates for 2023 are 0%, 15% or 20% depending on your income.
Some wealth events, like inheriting a real estate property or taxable brokerage account, will experience capital gains tax character. If so, consider:
- The capital gains rate (including the 3.8% NIIT, if applicable) that would apply to you
- Harvesting losses to offset gains: if you sold any investments at a loss in your taxable accounts during the same year, you can wipe out those gains for tax purposes and avoid paying the related taxes
Evaluate the Possibility of Minimizing Your Tax Bill
Taking into consideration the amount of the financial windfall, you may want to explore reducing your taxable income to minimize your taxes and stay below certain thresholds.
You can evaluate tax planning strategies, like:
- Maximizing pre-tax contributions to retirement plans
- For 2023, the limit is $22,500 for elective-deferral contributions to 401ks, 403bs, 457s as well as Thrift Savings Plans
- If you are 50 or older, the catch-up contribution is an additional $7,500
- Contributing to a Flexible Spending Account (FSA)
- For 2023, you can contribute as much as $3,050 to your FSA
- Contributing to a Health Savings Account (HSA)
- The HSA contribution limits for 2023 are $3,850 for self-only coverage and $7,750 for family coverage
- At age 55, you can contribute an additional $1,000
- Making Deductible Charitable Gifts
- Direct gifts to charities or a donor-advised fund (DAF) can reduce your income tax liability and fulfill your charitable objectives
- And more!
Navigating Your Emotions After a Sudden Wealth Event
So far, most of the discussion has been about the financial issues surrounding a sudden wealth event. However, a sudden influx of wealth can bring about a lot of emotions, like anxiety and stress, to name a couple. Receiving a larger sum of money than you’re accustomed to managing, especially all at once, can push you beyond your normal comfort level. You may want to make rash or impulsive financial decisions, and this is exactly what you don’t want to do.
Along with this, you may feel pressure from family members and friends on the best next step which adds to the stress levels. There’s also pressure you may put on yourself with the new money or asset, like helping family members or only using it for charitable causes.
Take time to process this transitional life event and avoid rushing into quick decisions without considering your long-term goals and values. With discipline and patience, you can make intentional choices instead of emotional ones.
Getting Professional Help and Modeling Windfalls in the NewRetirement Planner
Many people who experience a significant financial windfall can experience financial losses due to taxation, inadequate planning, and falling victim to exploitation. Seeking expertise from financial professionals to navigate this life event can be super valuable.
Strongly consider getting a tax pro (a CPA or IRS Enrolled Agent, not an uncertified tax preparer) to help you understand the tax implications of a sudden wealth event. A CERTIFIED FINANCIAL PLANNER™ professional is another great resource. NewRetirement Advisors are a low-cost option that uses the power of technology to deliver better advice.
You also can manage a lot of the planning issues through your NewRetirement Planning tool. There’s an entire section in the Planner dedicated to Windfalls, where you can enter after-tax liquid amounts to your plan to determine how the sudden wealth event will impact your long-term financial projection.