When a Windfall Lands
If You Choose the Wrong Strategy You Could Blow It

By Kathleen Day
Washington Post Staff Writer
Sunday, December 24, 2006

Cindy Drimmel just inherited $80,000 from her grandmother, and while she welcomes the money, she finds the options for using it overwhelming. Should she pay off her credit cards or her mortgage? Save more for retirement or pay off a car loan? Replace her roof or invest in a certificate of deposit?

"I knew I wanted to properly invest it, because that's what my grandma would have wanted, but I didn't know where to start," says Drimmell, a 23-year-old from Grand Rapids, Mich. "You get a thousand opinions, but how can you tell who's right?"

Financial windfalls come in many forms: a year-end bonus, a tax refund or even a winning lottery ticket. But for many people, figuring out what to do when an unexpected sum of money falls in their lap -- whether it's a few hundred or a few hundred thousand dollars -- is no easy call.

Popular options for handling a lump sum include paying down debt and buying a house, but those choices carry their own trade-offs, financial experts say. The experts recommend that recipients thoroughly review their own finances and completely understand the tax implications of a windfall before deciding what to do with the money.

No matter how you use a windfall, planners say it should have a long-term benefit, such as getting out of debt or saving for retirement. Don't blow it all on a new car or on items that could get you deeper in debt, like starting home renovations, which are notorious for costing more than anticipated.

"All it takes is for one thing to go wrong for things to turn bad very quickly," says Mary Malgoire, a financial planner in Bethesda.

Look in the Mirror

Financial experts say that making the most of a windfall starts with knowing your financial personality: Do you hoard money or spend too freely, or in amounts beyond your income? An honest assessment is essential, Malgoire says.

"It doesn't mean you have to accept who you are. You can change," she said. "But you have to be honest before you can change anything."

Recipients also need to know what taxes might be owed on the lump sum. You don't want a surprise tax bill, especially one you haven't set money aside for, says Anne L. Stone, a tax lawyer in McLean. She suggests contacting whoever sent the check -- the executor of a will or the state lottery office, for example -- to make sure.

When it comes to an inheritance, in Maryland and the District, a deceased person can typically pass on $1 million to a non-spouse before his or her estate has to pay a state transfer tax. The limit is $2 million before federal taxes kick in. In Virginia the limit is $2 million, the same as the federal cap, before a state transfer tax is incurred.

But income tax could be owed on money above or below those limits if it is interest earned on money held while an estate attorney figured out how to contact you. If the estate paid the tax on the interest, you won't owe it. If it didn't and instead passed the earned interest along to you, you might, Stone says.

Finally, recipients should analyze their income and spending to know where their money goes every month, from mortgage payments to lunch, financial planners say. That cash-flow analysis should also include a tally of all outstanding debts.

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."