The smart reaction to unanticipated cash? Spend some, save some — and don’t pay off the wrong debt.
For all your daydreaming about winning the lottery, you know it’s probably not going to happen. The odds of scoring the
life-changing top prize in any state lottery are no better than about 1 in 5 million.
But smaller windfalls happen all the time. The money might come from:
· An inheritance. The median value of inheritances received by baby boomers in a study was $49,000, but one-quarter of those who inherited money received $20,000 or less.
· A bonus. Many companies offer year-end or performance bonuses that typically range from one to two months’ pay, unless you are on Wall Street. Or you may get a windfall just for taking a new job. The average signing bonus for new graduates this year, for example, was expected to be $4,450, according to a recent survey of companies
· A judgment or lawsuit settlement. The median amount juries awarded to victims in car accident lawsuits was $15,000 in 2005.
Interestingly, there’s no one-size-fits-all advice about how to spend a windfall of, say, $10,000. What you should do
varies dramatically, depending on your stage in life and financial circumstances.
Here is one common scenarios with advice about what you should do.
The new graduate
You’re in your 20’s, a college graduate starting your career, with a fair amount of student loans and a bit of credit card debt. Here’s what to do with your windfall:
· Peel off $500 to party. It’s important to strike a balance between living today and saving for the future. Knowing its OK to enjoy a bit of every windfall will help you do smart stuff with the rest of it. You can travel or buy something nice for your apartment; the only requirement is that the expenditure give you pleasure.
· Give yourself a little padding. Don’t fall into the bad habit of living paycheck to paycheck. You need a cushion of cash to avoid bounced-transaction fees and to ensure that minor emergencies don’t wind up charged to your plastic.
· Invest $5,000 in a Roth Individual Retirement Account. There’s no better time to invest than right now, when your money has decades to grow. One $5,000 investment in a Roth IRA easily could translate into a $100,000 nest egg by the time you’re ready to retire, assuming 7% average annual returns (which is a reasonable assumption for the return on a diversified portfolio over the next 40 years). You don’t get an upfront tax deduction with a Roth IRA, but you’re not likely to get much of a tax break anyway, since your income and tax bracket are probably the lowest they will ever be. The tax benefit comes in retirement, when you can withdraw the money tax-free.
· Pay down any “toxic” debt. That debt includes credit card debt, payday loan advances and any other high interest, non-deductible loans. If you have anything left over after paying off such debts, you can use it to build your emergency fund or pay down any private student loans. (Unlike federal student loans that, tend to have low, fixed interest rates, private loan rates are typically higher and variable.)
For some financial transactions, you should use a credit card instead of cash or a debit card — even if you have the money in your pocket.
One thing you shouldn’t spend your windfall on: paying down federal student loans. This is probably the cheapest money you will ever borrow — and the most flexible, too, because it comes with various payment schedules. Plus you can get deferrals or forbearance if you run into tough economic times. The interest is usually tax-deductible, to boot.