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Widening Your Windfall

Considerations for Translating Lump Sums into Dividends

This year our NCAA tournament office pool totaled all of $200. And because the Loyola-Chicago Ramblers destroyed my bracket in the second round, I will not be walking away with the grand prize. No big deal. But if you work at Berkshire Hathaway, the winning bracket could land you a check for $100,000. And that got me thinking, what should you do with a windfall?

When we talk about windfalls, we’re not just talking about office pools or Powerball; inheriting money is far more common. In fact, $68 trillion of assets are expected to transfer to heirs and charities over the next 25 years [1].  If you don’t stand to inherit, perhaps a bonus at work is in your future. And even if you do find yourself with that winning lottery ticket, here are a few things to consider before you start spending it:

  1. Don’t make big decisions quickly. We talk with a lot of clients who feel like they need to “do something” with the money immediately. Maybe it’s making a purchase or perhaps getting money in the market right away. The market doesn’t know you just got a windfall, so take a second to breathe. If you’ve inherited money as a result of losing a loved one, it’s important to consider that you may not be in the right state of mind to make a big financial decision. While you wait, make sure your money is in a safe place. The FDIC covers up to $250,000 per bank per depositor and registration, so establishing individual accounts (and joint, if applicable) at multiple banks can help ensure appropriate coverage.
  2. Consider the tax consequences.
    1. Getting a Bonus – Being rewarded for doing a good job does usually result in higher taxes, but the good news is that there are a few things within your control:
      1. If you’re self-employed and having a better year than you expected, consider pulling any planned, deductible business expenses (computer, projects, office equipment, etc.) into the current year.
      2. If the money is not needed now, take advantage of a deferred compensation plan and maximize your 401(k) contribution. Doing so will shield that portion of your income in the current tax year.
      3. If you’re charitably inclined, consider using a donor-advised fund to pull forward future charitable contributions into the year of higher income. Grants to charity can be made in future years, but you get the charitable deduction all at once. Schwab, Fidelity, and American Endowment Foundation all offer these types of accounts, just to name a few
    2. Inheriting a Traditional IRA or 401k – You’ll owe taxes on any funds you take out of these accounts, so it’s generally better to keep funds inside the IRA as long as you are able. The good news is that selling an asset inside of the account does not result in taxes, in and of itself. This is important because you may have a different risk tolerance or return objective than the benefactor and you may wish to change how the account is invested. It’s also important to note that these accounts carry with them required distributions, so you may need help from a CPA or an investment advisor to ensure that distributions required by the IRS are satisfied to avoid penalties (see step 3 below).
    3. Inheriting a Taxable Account – Under current law, if you inherit money in a non-retirement account, you can take advantage of what is known as the “step up” in basis, which means that the value of the investment on the benefactor’s date of death becomes your new cost basis for the asset. Suppose, for example, that Aunt Mabel left you her Apple stock. She bought it at $1 and when she died it was trading at $100. After taking advantage of the step up, if you sold, you would pay taxes only on the growth over and above $100, not starting at her original basis of $1. As someone who looks at a lot of investment statements, I’m often surprised by how many people don’t take advantage of the “step up” and update their cost basis. To take advantage of this rule, simply let your advisor or custodian know that you inherited the assets and provide a death certificate along with the valuation date and price of the security to get your cost basis updated.
    4. Winning a Bracket Pool/Lottery – Yes, winning a bracket pool or lottery is counted as income. For amounts over $600, winners should expect to receive a 1099. If the payout is significant and taxes are not withheld, you may need to make an estimated payment in advance of your tax filing deadline to avoid penalties. Interestingly, the IRS distinguishes between gambling and hobbies that require “skill,” such as winning a bracket challenge. This distinction allows winners the ability to deduct the cost of your entry fee against winnings as a miscellaneous deduction if certain thresholds are met. If you are one of the rare people who has won the lottery, you should expect to receive a W-2G from the lottery agency. Mandatory 24% withholdings are required for winnings of more than $5,000, but if you hit it big, you may need to make an estimated payment to avoid penalties at tax time.

Regardless of your situation, once you have determined the amount needed for taxes, earmark those funds and put them in a safe place. A certificate of deposit, money market, or bullet bond with a set maturity date are viable options for earning interest while you wait to pay your taxes.

Sir John Tenniel’s rendering of the Cheshire Cat, circa 1889.
  1. Make a plan. At Balentine, we often reference the Cheshire Cat in Lewis Carroll’s “Alice in Wonderland” when explaining the importance of planning for the future. The cat quips that, “if you don’t know where you’re going, any road can take you there.” The cat was right: a planner can help you find the right road, but first we need to understand where you want to go. Here are a few scenarios to think through:
    1. Is the lump sum large enough that it can change your lifestyle?
      1. If so, you may want to consider hiring a financial planner to help you come up with a plan that balances providing income now versus growth for income in the future.
      2. If you’re not accustomed to managing money on your own, you might consider hiring a tax professional who can help guide you through the varying tax implications of investing in different asset classes. Bitcoin and hedge funds, for example, can carry complex tax reporting requirements that may require professional assistance. Some states also charge inheritance taxes that can impact the donee, and inherited IRAs carry with them required distributions and deadlines that must be met to avoid IRS penalties.
      3. Put an estate plan in place if you don’t already have one. Determining who would receive your various assets in the absence of a will is a great place to start. If you don’t want your estate to devolve in that way, you will have to take affirmative action. Remember, certain assets such as life insurance will devolve to the designated beneficiary. So, it is very important to make sure your beneficiary designations are all up to date. Other accounts wholly in your name can’t be immediately accessed by your surviving spouse or executor, so you might consider adding a spouse or caregiver to the account to give them more flexibility to do things like pay bills before the estate is opened and an executor is appointed. Finally, you may wish to designate a trusted person as executor of your estate to ensure matters are handled according to your wishes.
      4. Give some of it away to those who need it more than you do!
    2. If the amount won’t change your lifestyle, use your windfall to get your finances in order.
      1. First, do you have an emergency fund? If not, consider setting aside 6-12 months of living expenses that you could access quickly. It doesn’t all have to be in cash, but it does have to be liquid and safe. This is not the place for Tesla, Gamestop, etc.
      2. Do you have any high interest debt, such as credit cards or student loans, that it makes sense to pay off? In the current low interest rate environment, anything over a 5% annual rate makes sense to pay down quickly for most investors.
      3. If you have kids or grandkids, consider “superfunding” a 529 college savings plan. Superfunding is simply a means of gifting five years’ worth of contributions at one time to a 529. In 2021, this means that you could gift up to $75,000 per child (couples could give up to $150,000 per child).
      4. If you have already maxed your 401(k), consider developing a plan to dollar cost average into a taxable investment account.
  2. Spend some. It can be tempting to skip straight to this step, but before you buy that Ferrari, remember that no one is impressed by your possessions as much as you are. “If you are seeking respect and admiration, you are more likely to gain those things through kindness and humility than with horsepower and chrome,” counsels Morgan Housel in his book, Psychology of Money. A better use of your windfall might be to buy yourself some time. Moving to a neighborhood that shortens your commute or springing for the non-stop flight so that you can spend more time with family and friends are just two examples.

While windfalls are by their very nature unexpected, “easy come” doesn’t always have to mean “easy go.” Take your time, and don’t make big decisions quickly. Consider the tax implications before you pull the trigger on any sales. If you need help, hire professionals to assist you. Then, spend some. And whatever you decide, you’ll want to earmark some funds for next year’s bracket.

[1] https://info.cerulli.com/HNW-Transfer-of-Wealth-Cerulli.html 

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