A FEW WEEKS AGO, life changed for 24-year-old Manuel Franco of West Allis, Wisconsin. The winner of a recent Powerball lottery, Franco took home $326 million—and that’s after taxes. With a sum that large, it shouldn’t be hard for Franco to make his winnings last a lifetime.
And yet, more often than not, such windfalls deliver heartache rather than happiness. Consider Lara and Roger Griffiths, an English couple who, in 2005, won the equivalent of $3.2 million from their local lottery. After celebrating with a spray of champagne, they both quit their jobs to go on a buying spree: three houses, sports cars, jewelry and vacations in Dubai, Monaco and Majorca. Result: The couple were penniless just six years later.
To be sure, the Griffiths’s story is extreme. But if you’re the recipient of a windfall—whether from a year-end bonus, stock options, the sale of a home, an inheritance or even just a tax refund—it’s important to employ a logical framework when allocating these new funds. Below is the 10-step process I recommend:
Step 1: Set aside for taxes. If the windfall is six figures or larger, the first step is to visit your accountant. Even if the check you receive withholds some amount for taxes, that’s often just an estimate. Only your accountant knows your entire picture well enough to make an accurate estimate of the taxes owed. Take that amount and stash it in a separate FDIC-insured savings account.
Step 2: Diversify. If your windfall came in the form of company stock, it may be tempting to hold onto it. After all, you know the company and you may incur further taxes to sell your shares. But I would encourage you to think about it this way: If you didn’t already own the stock and didn’t work for the company, how much of this one company’s shares would you buy? I wouldn’t let any single company’s stock account for more than 5% or 10% of your net worth.
Step 3: Eliminate high-interest debt. If you’re carrying credit card debt, pay it off. If your credit cards charge 18%, which is the current average, you’ll earn the equivalent of a guaranteed, tax-free 18%.
Step 4: Evaluate lower-interest-rate debt. While I wouldn’t hesitate to pay off high-rate debt, you don’t need to eliminate all debt. If you have a very low-rate mortgage or car loan, it might make sense to keep the loan, even if you could afford to pay it off—for two reasons.
First, you might be able to earn more, over the long term, by investing those funds. Second, and maybe more important, it buys you flexibility. You can always pay down debt later, but—at that juncture—it might be much harder to take out a new loan if you find yourself short on cash. Banks, it’s often said, prefer to lend money to people who don’t need it.
Step 5: Set aside for charity. If your windfall will push you into a higher tax bracket, charitable gifts are an effective way to moderate the resulting tax bill. As I’ve recommended in the past, a donor-advised fund is an easy, flexible and effective way to support charitable causes, while also immediately cutting your tax bill.
Step 6: Consider gifts to family. Depending on the size of your windfall, you might make gifts to family members—but do so carefully. Think about equity among recipients. Also be sure to set expectations. Is this a onetime gift or the start of regular, annual gifts? Whatever your plan, everyone will be happier if you communicate it upfront.
Step 7: Do something meaningful. Economists caution against “mental accounting”—that is, treating money differently depending on its source. To a purely rational mind, money should be fungible.
But most people aren’t purely rational, and that’s okay. I think it’s completely reasonable to use part of a windfall to purchase, or do, something that carries sentimental value. You could, for example, use part of an inheritance to buy something special for your home, which will serve as an ongoing reminder of the person who made the bequest.
Step 8: Do something frivolous. As important as it is to do something meaningful, I also advise doing something frivolous. Why? Because it is largely unavoidable. It’s the rare person who won’t be tempted to do something fun. Recognizing that reality, I think it’s better to budget for this. That’s what got Lara and Roger Griffiths in trouble: If it had been just the McMansion, or just the sports car, or just the jewelry, they probably would have been fine. My advice: Have fun—but within a prescribed limit.
Step 9: Save the rest—slowly and with an eye toward tax-efficiency. After making each of the above allotments, you’ll want to save the rest. But don’t rush to invest it. With stocks, bonds and real estate near all-time highs, I don’t see any urgency to jump into the market.
Instead, give things time to settle down and think through your long-term plan. Because your tax rate may be quite a bit higher in the year you receive a windfall, you’ll want to avoid strategies that’ll boost your tax bill and you might seek ways to trim taxes, such as maxing out tax-deductible retirement accounts.
Step 10: Keep a low profile. If you saw Lara and Roger Griffiths on the day they won the lottery, they were anything but discreet. Nothing good comes from drawing attention to yourself. Indeed, it only makes it harder to follow the nine earlier steps carefully, methodically and on your own terms.
Adam M. Grossman’s previous articles include Out of Bounds, Not So Easy, Many Happy Returns and Oracle of Boston. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.