What if you are lucky enough to get a windfall? Maybe a small inheritance from a long-lost cousin, or even something modest like a $2,000 tax refund or the $10,000 bonus Boeing Machinists just received in their paychecks Jan. 16 for signing a new contract.
For most Americans, $2,000 or $10,000 is a nice treat — not life-changing, but a chance to pamper themselves or catch up with finances they’ve been neglecting. But how do you make this one-time windfall count? Ideally, this would be the time to start saving for retirement or to fulfill your promise to yourself to save more.
For people with children, it could be the opportunity to start a college savings plan. Or it could be just what you need to finally have enough for the down payment on a home, or to reduce the weight of credit-card debt or college student loans.
If you’ve never had an emergency fund, you could tap that windfall for a start.
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But if you are like most people, a windfall creates an urge to spend — to give yourself something special.
Glenda Moehlenpah, a San Diego financial planner, suggests people realize that rather than denying the feeling.
Even though it would probably be wise to devote an entire windfall to paying off debts or saving for the future, forcing yourself to do what’s purely prudent might backfire, she said. So her advice is to indulge yourself with maybe 5 or 10 percent of the windfall and do what’s wise with the rest.
“A lot of times, if you let yourself spend some, it will keep you from spending too much later,” Moehlenpah said. “Really splurge; make it really enjoyable.”
Then, realize that with the rest of the money you are also preparing yourself to enjoy your future.
For example, the Boeing Machinists who just signed a contract received a $10,000 bonus, but the other side of the deal involved agreeing to have their pensions frozen and replaced by a 401(k) with a small company match in the future. That means that if they are relatively young and don’t save more for their future, they are likely to end up living on a shoestring in retirement.
Let’s say a Machinist is 35 and puts $5,500 into a Roth IRA this year, investing it in a mutual fund, called a “balanced fund,” that invests 60 percent of his money into stocks and 40 percent into bonds.
In the next 30 years, that money could average an 8 percent annual gain if the fund behaves the way it has historically. So that one-time $5,500 would end up totaling about $55,000 for retirement. When you look at it that way, you get a lot more out of investing $5,500 than just blowing it on something fun.
Likewise, $5,500 could help make it easier for your children to go to college without borrowing as much as they might.
Let’s say the 35-year-old puts $5,500 into a 529 college savings plan, and the child will be going to college in 10 years. Maybe the money earns 6 percent a year on average.
In that case, the child will have about $10,000 for college. That, of course, isn’t going to cover the cost of college, which can now run about $20,000 a year or more. But it helps.
Of course, if you are short on both retirement and college savings, you could split your windfall between the two funds for your future.
For the retirement money, you will get the most mileage if you put it into a 401(k) at work or a Roth IRA if you don’t have a 401(k). Both are protected from taxes, so they help your money grow more than if you put it into an account that was taxed. And if your employer will give you matching money for a 401(k) contribution, make sure you choose that option and get all the free money you can on the job.
For the college fund, choose a 529 plan from your state or another state. Those plans are protected from taxes, too, and some states give you an extra tax bonus or other incentive for using them. Scout for 529 plans at morningstar.com.
Of course, if you are carrying 18 percent debt on your credit cards from one month to the next, the nicest thing you could do for yourself would be to wipe that out.
But Moehlenpah is skeptical of this approach — again because of your head, not solid financial planning.
It’s too easy for people to wipe out their debt with a windfall, she said. In her experience, people who do that end up running up debt all over again. Yet when people feel the pain of paying off their debts month after month, they vow never to get in over their heads in debt again. And they tend to be successful with such a promise, Moehlenpah says.
So consider dividing that windfall into parts such as fun, debt reduction, retirement and college.