If you’re human, you probably have day-dreamed about how you would spend a sudden windfall. For some of us, an exotic vacation or new car might top our list.  For others, the more practical may hold sway as we put money away for retirement or a child’s college expenses.

Whatever your financial dreams, the suddenness of winning a lottery, inheriting a large sum of money or selling your practice or business often doesn’t leave time for pre-planning. That’s why it is important to consider these steps if you come into sudden wealth.

 

Breathe

If you’re tempted to run out and purchase a $100,000 car before the ink on your windfall check has dried, don’t. Take a step back and breathe. With great wealth comes great responsibility, and your windfall can create all sorts of complications you’ll want to avoid, if possible.

Call a family meeting and discuss the pros and cons of your circumstances. Talk to your trusted advisors, including tax, legal and financial professionals. Above all, work with your advisors to draft a plan showing how you will invest and manage your windfall. Then, create a wish list of ways you will spend your windfall – and how much of it.

 

Pay Your Taxes

Why mention taxes first after taking a deep breath? Few financial windfalls in life escape the touch of local and federal tax authorities, and chances are you never had a tax bill this large in your life, so you’ll want to put a percentage of any windfall away to meet this obligation. Your windfall is net after taxes, not before.

Most taxes will be paid by the estate before the money reaches you. (The estate is the term given to all the money and stuff left behind by someone after they pass away). The executor, also called the administrator in certain situations, is responsible for settling the debts of the estate before distributing the money. This means settling up on any outstanding tax bills.

Large estates (+$12M or double if married) can get hit with Federal estate and transfer taxes. These are onerous and also complicated taxes to pay, but fewer than 0.1%[1] of estates are large enough to get hit by these taxes in the first place. Maryland, however, faces a lower estate tax threshold at just $5M per person. The majority of estates will simply file a final income tax return for the decedent and settle up on any outstanding property taxes. Money flows to heirs after that.

What you inherit will be largely tax free, but there are notable exceptions for inherited retirement accounts. These are taxed only upon withdrawal. The estate will pay the tax on any withdrawals for the year in which the decedent passed away, but you will pay tax in all future years. This could be significant if the IRA was large, and potentially troublesome tax-wise if you’re also a high income earner. Inherited retirement accounts have ten years to distribute all funds, an annual required distribution, or both in some situations! This can force you to recognize income you may not need.

Make sure you connect with the right tax and financial planning professionals to ensure you’re not leaving any money on the table when it comes to your newfound inheritance.

 

Give to Charity

We list giving to charity next because it can lower your tax bills. Making charitable contributions to groups and causes near to your heart can create enormous emotional satisfaction that exceeds the financial support you give to these organizations. But another benefit to charitable giving is that contributions to qualified charitable organizations can dramatically lower your tax liability.

 Consider getting together with loved ones to discuss the charities that mean the most to all of you. Then consider how you will give. This could be a lump sum, annual contributions or even an annuity or insurance policy funded by some of your windfall.

You may consider doing qualified charitable distributions (QCDs) from inherited retirement accounts. Distributions are required from these kinds of accounts annually in most situations, and a QCD can help you avoid tax on the distribution while also meeting your charitable goals.

Donor Advised Funds (DAFs) can also help if you’re donating taxable property, such as low-basis investments from a brokerage account. A single donation can be made in one year but distributed over the course of several future years. And the best part – you don’t have to name a specific charity when you donate! You can decide as you go. This allows you to make a charitable contribution large enough to be worth itemizing on your tax return (i.e. miscellaneous deductions are larger than your standard deduction) while sorting out the details later.

Side by side comparison of donating stock vs selling and donating proceeds

As always, you’ll want to consult your financial and tax advisors in addition to an estate planning attorney.

 

Take Care of Now

You planned and took care of taxes. Now it’s time to spend. Look at your debts and consider which ones to reduce or eliminate. Get rid of high credit card balances, especially those charging the highest interest rates. These rates have gone up with interest rates in general. If you’ll stay in your current home, now is a good time to see where you need to make improvements or expensive repairs. Same goes if you need to replace an old beater of a vehicle.

Look at longer-term financial goals, such as funding your retirement or a child’s college education, and create a plan to meet each goal. The combination of time and compounding may help your investments grow. Because there are as many ways to accomplish each as there are people, work with your advisors to develop plans that fit your situation. Don’t forget to consider funding other long-term possibilities, such as the potential need for long-term care.

Finally, consider establishing an annual gifting program for family members. You and a spouse can both make annual gifts to as many people as you like, free of federal gift taxes, if you don’t exceed $16,000 (in 2022) per person. If you and wife both gift this to five people, that’s 10 times $16,000 – or $160,000, that comes off your eventual estate – reducing the eventual estate taxes your beneficiaries would owe.

 

Splurge a Little

Now that you’ve taken care of the necessities, you might want to consider that exotic vacation or sports car you had your eye on. You’ll be able to do this with a clear mind because you planned before spending a dime. With planning, your windfall can do wonders for you and your loved ones instead of creating a headache that follows you throughout life.

[1] Tax Policy Center. “How many people pay the estate tax.” Taxpolicycenter.org. May, 2020. https://www.taxpolicycenter.org/briefing-book/how-many-people-pay-estate-tax#:~:text=Individual%20Taxes-,How%20many%20people%20pay%20the%20estate%20tax%3F,few%20estates%20pay%20the%20tax. Accessed 29 September 2022.


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