When a Windfall Lands

If the money is a lump-sum payment for early retirement or even something as exotic as a book advance, then it might be a good idea to treat it as a condensed salary, parceling out the cash over time like a paycheck, says Peg Downey, a financial planner in Silver Spring.

"Managing cash flow is the key to financial success," Malgoire says. "A windfall doesn't ever change that."

Here's the Payoff

For many people, an unexpected chunk of money presents an opportunity to pay off credit card bills or other high-interest debt -- Drimmel, for example, has already used part of her inheritance to pay off debt on one credit card. But she still has $6,000 in bills on other credit cards, a $13,000 car loan and two mortgages on her house. She is thinking about applying another portion of the inheritance to those debts.

Financial experts say that eliminating debt, particularly on credit cards, makes a lot of sense but must be paired with a change in spending habits. "People who are running up their credit cards are living beyond their means," says Sophie Beckmann, a financial planning specialist at A.G. Edwards. "Getting a windfall might be a good time to get priorities straight."

Paying down mortgage debt, however, is more complicated. If you are close to retirement, Beckmann and others say, paying off your mortgage is good because it eliminates what for many is the largest single monthly expense.

But many planners say it also makes sense to keep mortgage debt -- if it's at a good rate -- because you can deduct the interest you pay on it from your taxable income. Instead of using a lump sum to pay it off, you might find that money works more effectively elsewhere. For example, if you are paying 6 percent for a mortgage and your marginal tax rate is 25 percent, then really you are paying an after-tax rate of 4.5 percent rate on that loan. If you can invest the lump sum in a certificate of deposit offering 6 percent, you might be better off putting the money there -- or into other high-yield securities, such as a mutual fund.

Real Estate Smarts

Buying real estate is another common way to use a windfall, which for some recipients can be the ticket to home ownership. Applying the money toward a bigger down payment on a home can help get a better mortgage interest rate, but financial experts say that paying off high-cost debt and shoring up retirement savings should probably take priority.

Sinking too much of your savings into a house carries its own risk and could leave your investment portfolio insufficiently diversified, planners say. Homes typically appreciate over the long haul -- another factor to consider when weighing investment options. But they can also lose value and may be hard to sell quickly in the short run, which could be a problem if you need money for an emergency.

If you can, planners recommend putting part of the lump sum into a savings account. Beckmann says this season, taxpayers expecting a refund have a new opportunity: The IRS for the first time will permit refunds to be split and automatically deposited into as many as three accounts. The smartest thing many people could do, she says, would be to open an IRA, a retirement savings account that offers tax advantages. A traditional IRA lets account holders deduct up to a certain amount in contributions from their taxable income; in 2006, that limit is $4,000. Under a Roth IRA, contributions cannot be deducted, but what's in the account can be withdrawn tax free at retirement.

If you have children, you might consider putting a portion of the windfall into a 529 college fund. Each parent and grandparent (or anyone else) can give $60,000 over five years to a child tax free by using these funds, if the money is eventually used to pay for education. But don't rob your retirement to pay for college: You can borrow to pay for tuition, but in general not for retirement, Beckmann says.

Small Treats, Big Business

Of course, many people who get money they weren't expecting feel an urge to spend it on a treat for themselves. Malgoire says recipients should give in to that temptation -- but within reason.

"Buy the iPod or take the cruise, but don't blow it all," she says. "It should be a small, token piece of the entire amount."

The co-owners of College Hunks Hauling Junk of Rockville looked temptation in the eye a few weeks ago, after a $7,500 check arrived from George Washington University for a job clearing out old furniture. It was the second largest single payment they'd received since founding the company 18 months ago, and like many small-business owners, their personal finances are interwoven with the company's.

"As young, energetic bachelors, receiving a larger-than-normal check is very tempting on an emotional level, especially around the holidays," Nick Friedman, 25, says of himself and co-owner Omar Soliman, 24.

So what did those junk-hauling bachelors do? After 10 days mulling options -- and the advice of their accountant -- the two decided on a plan the experts would like. They gave themselves a gift of $1,000 each for shopping and end-of-year celebrations. They already have retirement savings accounts, so they put the rest back into their business: They spent $2,000 to pay off the balance of a $10,000 debt they incurred to buy a toll-free number, 1-800-Junk-USA, that they hope will help build a franchise nationwide, and $3,500 on a lawyer to help craft that franchise plan.

"The thrill-seeker inside of us is saying we should spend the money on a fancy vacation or maybe make a down payment on a new luxury car," Friedman says. "But the business owner inside of us is a bit more rational."