Tuesday, December 19, 2017

How to Use a Year-End Windfall Wisely

It is not uncommon for people to receive extra income at the end of the year. Some workers receive a year-end holiday bonus or special distribution from their employer and more affluent ones may have reached the maximum taxable earnings limit for Social Security (FICA tax) deductions and/or the maximum amount that can be contributed annually to a tax-deferred TSP, 401(k), or 403(b) plan. There’s also the possibility of receiving a generous holiday cash gift.
How should a year-end cash windfall be used? Like most financial planning questions, the best answer is “it depends.” Some key factors include a person’s age, financial goals, net worth, cash flow, and amount of existing savings and investments.
Below are ten suggestions for investing a cash windfall:
  • Fund an Emergency Reserve- Experts advise setting aside three to six months expenses in an accessible place such as a money market mutual fund or bank savings account. That is $6,000 to $12,000 if expenses are $2,000 per month. An emergency fund provides ready cash when “stuff happens” in life (e.g., sick children, injured pets, car repairs).
  • Reduce Debt- Repay the outstanding balance on high-interest loans or credit cards. Start with debts that charge the highest interest. For example, many department store credit cards charge annual percentage rates of 20%+.  Paying off a 22% APR credit card is equivalent to earning a 22% investment return: guaranteed, risk-free, and tax-free.
  • Invest for Retirement- Put your cash windfall in a Roth or traditional individual retirement account (IRA). Any amount that you invest will grow significantly after decades of compound interest. Taxpayers have until the tax filing deadline of the following year (typically April 15, unless a weekend/holiday) to fund an IRA for the previous tax year.
  • Invest in Yourself- Economists refer to workers’ knowledge, experiences, and skill sets as “human capital” and a cash windfall can be used to maintain or improve it. Some examples include attending a professional conference, paying for course credits for a college degree program, or taking courses or training for career advancement.
  • Invest in a Child-Add to the college fund of a child or student.  Depending on the type of investment that you make, you may be able to save on your income taxes. A financial advisor can help you decide.
  • Remodel Your Home- If you plan to stay put for a while, consider using a cash windfall to make a small home renovation such as new carpeting, flooring, or bathroom fixtures. If you plan to move soon, use the money for cosmetic changes that will increase your home’s resale value (e.g., new doors and outdoor landscaping).
  • Open a Mutual Fund Account- Many mutual funds allow investors to open up an account for $1,000 to $3,000 (or less) with $25 to $100 subsequent minimum deposits. By investing in a mutual fund, investors receive broad diversification of their invested cash and professional management of the mutual fund’s investment portfolio.
  • See a Financial Advisor- Extra money can be well spent by seeing a financial advisor to get answers to your questions and direction for the future. Many financial planners charge hourly rates like lawyers do and some focus their practices exclusively on middle-income households. To save time (and, therefore, money), go prepared for an appointment with a list of question and copies of relevant documents (e.g., copy of latest tax return).
  • Be Charitable- Some people elect to use part of a cash windfall to help others via donations to their favorite charity or educational institution. Donations sent via U.S. mail must be postmarked by Saturday, December 30, 2017 to count as an itemized deduction in 2017. Another giving option is to provide cash gifts to family members.
  • Go on a Spending Spree- It is perfectly fine to use a cash windfall for fun things like shopping and entertainment. Some financial experts recommend carving out a specific piece of a windfall (e.g., 10%- 25%) for a spree.  A related option is upgrading a previously planned financial goal (e.g. choosing more options for a new car or vacation trip).
    Consider combining two or more of the ideas listed above. For example, 40% emergency fund, 40% home improvement, and 20% fun activities. It is also perfectly fine to take your time to decide what to do with a cash windfall. Simply “park” this money in a money market fund or savings account until you develop a plan.

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