Q.

What should I do with a windfall, such as a $500K inheritance from a long lost Uncle or a larger sign-on bonus than expected?

A.
Two of my favorite investing/finance books, The Bogleheads Guide To Investing, and The Only Investment Guide You'll Ever Need, each have an entire chapter on this subject that are well worth reading.  The Bogleheads Wiki also has a nice page on it.  I prefer to divide windfalls into three categories:

Category 1: Spare Cash

This is money, perhaps $10-200K, that you weren't expecting.  I would just fold this money into my existing financial plan.  For example, I might be paying off student loans, paying down a mortgage, trying to max out retirement accounts, putting money toward the kid's college, and trying to save up for a new car.  I'd just take this money and divide it among my goals in whatever manner I see fit, trying to minimize interest, decrease taxes, and maximize returns.  Right out of residency, it might all go toward my student loans.  If I were 50, it might go all toward the mortgage.  But more likely, it would be split between the various options.  If you're not maxing your current retirement accounts, perhaps live off the windfall for a few months to allow you to max them out, essentially converting a taxable account to a tax-protected account.

Category 2: Enough Money To Make You Financially Independent

Consider this an inheritance of $1-2 Million.  This is enough money to really change your life in a significant way.  The best thing to do upon getting this money is nothing, at least for a period of a few months or a year.  Give it some time and really think about what you want to do with your life.  Ready to retire?  Do so.  Want to get out of medicine and write books?  Now's your chance.  Still love what you're doing?  Perhaps put a chunk toward retirement, give some away, and spend some.

Category 3: Ridiculous Money

This is when you get a windfall, such as lottery winnings, which if invested wisely, is more money than you would ever spend given your current lifestyle.  While somewhat similar to category 2, it is different in some important ways.  You now need to engage in some serious estate planning for instance.  You also have the opportunity to make real change in your community and the world, a responsibility not to be taken lightly.  You'll also have to fend off the hordes who want you to share the money with them!

I really like Andrew Tobias's recommendations for what to do if you win a million dollars.  Here's what he says:

1) Go out for a very nice dinner.

2) Put about one year of normal living expenses someplace liquid, like a bank or money market fund.

3) Put roughly equal sums into US Treasury securities maturing in one, two, three, and four years.

4) Put the bulk of the remaining money into stock-index funds, split between domestic and foreign investments.

5) Buy a country place or a bigger house, if you want one–but not so big that the cost of carrying it will in any way strain you.  5A- If you have the inclination and can find a good value, buy a small rental property too.  It will provide an inflation hedge and a little tax shelter.  5B- Do not buy a boat.

6) Be sure your will is in order.

7) Now, relax and forget the whole thing.  Review it once a year, mainly to roll over your treasury securities as they come due.  Don't spend any of the investment principal, but enjoy the extra income it throws off.

I find it interesting that these recommendations aren't really very different from what he recommends you do if you DON'T win a million dollars.  Now, here's what I recommend you do with any significantly sized windfall.

Ten Rules For Managing A Large Windfall

1) Don't do anything quickly.  There is no rush.  Especially if the windfall is life insurance proceeds from the death of a loved one.

2) If we're talking about ridiculous money such as lottery winnings, try to keep anyone you know from finding out you have this money or how much it is.  It is far more likely to ruin your life than to help it.

3) Consider annuitizing the money.  Most lottery winners are broke within just a few years.  If you annuitize it, at least over 20 years or more, you've got to screw up 20 separate times to go broke.  That's a lot harder than screwing up once.

4) Seek out some solid, unbiased advice.  Talk to a CPA for some tax advice and an attorney for some estate planning and asset protection advice.  Pay them a fair, hourly rate.  You may need to update insurance, especially liability insurance.  Investing advice is far less important early on.

5) Pay off your debts.  Don't take on any more.  Life is no longer about increasing returns, but about minimizing risks.  Having debt generally increases your risks.

6) Put a big chunk of the money into very safe investments-CDs, treasuries, bank accounts, money market funds etc.  You now have a much lower need to take investment risk than you had prior to this windfall.  Take advantage of that by taking less risk.

7) Spend some money.  But don't spend it on something that requires significant ongoing expenses.  Take a luxurious trip around the world or buy a new truck or something.  Don't buy a 10,000 square foot house or a $2 Million yacht.

8) Give some money away….to some real charities, not your brother-in-law and Ray across the street.

9) Write down a plan for how you're going to deal financially with family and friends.  Tell them what it is, and stick to it.

10) Remember that one of the benefits of having enough money is that you don't have to maximize it.  You only need a plan that is good enough.  You don't need to get every last dollar out of your inheritance.  As Tobias says, not having to try [to maximize the money] is one of the luxuries that being a millionaire should bring.

What do you think?  Have you had a windfall?  What did you do with it?  What advice do you have to someone who comes into $50K, $2 Million, or $100 Million?  Comment below!

Image Credit: Sergio Pitrau, via wikimedia, CC-BY-SA