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What Should You Do With That Chunk of Cash?

Personal Finance How-To

Tax returns. Bonuses. Insurance settlements. Divorce. Inheritance.  Tax refunds (should you be so lucky!). All of these are reasons you might receive money that isn’t part of your normal cash flow. In some cases the amount could be enough to significantly change your financial path, but for others, it may simply provide a little boost toward certain financial goals.

In either scenario, the extra cash may raise more questions than answers. How do you prioritize where to put these funds to work?

A simple framework 

No two people’s financial priorities are exactly alike. But just to give a rule of thumb, here is a good order to follow when deciding which financial goals to tackle first.

  1. Pay off high-interest debt. Remember the power of compound interest, or interest earned on interest. High-interest debt compounds quickly, and can threaten the rest of your financial picture. This is particularly appealing in a near-zero interest rate climate as you would be paying far higher than you are earning on short-term dollars.
  2. Make sure you have appropriate cash reserves: This protects you from emergencies, allowing you to “be your own bank” and avoid high-interest debt. We typically suggest saving 3 – 6 months of your core expenses, but this will depend on how you earn money.  If your earnings can fluctuate, be sure to build reserves equal to the lag time of inflows.
  3. Max out pre-tax retirement accounts. This reduces your taxable income. The pre-tax contribution limit for 2016 per individual is $18,000, plus an extra $6000 “catch-up” contribution for those over age 50.
  4. Build an after-tax investment account. It is crucial to have both pre-tax and after-tax accounts because both have different advantages and drawbacks. Workplace retirement accounts funded with pre-tax money allow your investments to grow tax-deferred, but you will eventually have to pay taxes on the withdrawals. Tax-deferred plans are drawn down much faster than after-tax plans for this reason.  Because you have already paid the taxes on after-tax investment funds, this type of account gives you extra diversification and retirement security.
  5. Save for college expenses if applicable. Use a 529 plan with low-cost funds.  The inflation on college costs is about 6% per year, so if your goal is to pay for college, then consider treating this goal much like you would a credit card balance and “pay it down” sooner. Find more tips for college funding here.
  6. Pay down other debts and loans. Paying off all your debts immediately may seem like the obvious choice, but there is more to it than meets the eye. Where can your money benefit your net worth the most? High-interest debt (as mentioned above) can pose a significant threat to your financial stability. But lower-interest debt (mortgage, auto, etc.) that eventually becomes equity, or an asset, should not be as much of a concern as long as your total debt remains under about 30% of your take-home pay.

The psychological side of “sudden money”

A very large financial windfall can have emotional repercussions too. Receiving a large inheritance, for example, can bring conflicted feelings of both loss and relief that you now have the funds to meet certain financial goals. Some people may respond to large sums of money by trying to get rid of it as soon as possible so they don’t have to think about it—while others may feel analysis paralysis given all of the available options.

Sometimes the wisest thing to do is to take a time out. While of course there is an opportunity loss to keeping too much money in cash, if taking a “time out” will help you avoid a rash decision, it can be a positive move. Money doesn’t go bad, so don’t feel like you need to act immediately. Just make sure you set a “check-in” deadline for yourself to think about what you would like to achieve, and make a list. Taking some time to think may also spark an idea to earmark some of the money for a specific goal that would honor the source of the money, such as a charity donation, scholarship fund or event.

After you have time to collect your thoughts,  sit down with an advisor.  Make sure this advisor is a fee-only fiduciary who will make recommendations according to your best interest, and who can help you to prioritize your goals.

At Halpern Financial, we take a holistic view of your financial life to help you with decisions such as how to properly allocate a windfall. We are happy to answer your questions and listen to your concerns about the process. Please don’t hesitate to reach out if this situation rings true for you!

Photo used under public domain.


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