Quick riches can sometimes bring long-term financial misery.
Andrew Jackson “Jack” Whittaker is a legendary lottery winner. Not only was he one of the largest lottery payouts with $314 million. He is also squandered those winnings in record time, a mere 4 years.
How does one lose 9 figures so quickly?
There were failed investments in family business ventures. Also, large chunks of his winnings were lost to gambling and legal troubles. Since the story of Midas, there have been tales of wealthy men who suffered from their riches and Jack Whittaker puts a real face to the narrative.
While you and I will never get a chance to spend hundreds of millions of dollars, obtaining a substantial income windfall is quite common. Remember the larger than expected tax refund, the big promotion that sent you to a whole new tax bracket, the performance bonus to end all performance bonuses and the inheritance from your rich step-uncle, four times removed, on your mother’s side?
These types of windfalls happen all the time and while they may not be more than a few thousand dollars, families stand to suffer the wealth misery curse if they aren’t careful about making smart financial choices.
If you find yourself with a large chunk of extra money, I can’t begin to tell you the best way to spend it, but I can offer some smart approaches to financial decision-making that will decrease the odds of later regrets.
Smartest Approach: Use a Windfall to Realize One of Your Planned Financial Goals
One of the best ways to spend windfalls is to spend it exactly as you’ve already planned. If your financial goal has been to be debt free, or retire in three years, or saving to take a dream vacation to the Andes; perhaps you should use your windfall to accomplish the goals you’ve already set for yourself?
There is a very important reason why this approach is the smartest. You set your goals before you had realized an income windfall. The goals were within your reach before the extra money and as a result, you won’t be over-extending yourself financially given your new situation. Instead, you are simply accomplishing the goal earlier than expected.
However, don’t confuse “your current financial goals” with expenses that you’ve always wanted to make. It is easy to justify big expenses as smart when there are sudden income windfalls burning a hole in your pocket. Your current financial goals are those that you were actively pursuing. If you had an Italy travel fund before the windfall, then an Italy trip was a financial goal. However, fulfilling your dream of owning a Ferrari is not a financial goal, it is a life-long want.
Smart Approach: Use a Windfall to Seize an Uncommon Opportunity
The unexpected influx of money opens the door to opportunities that we never thought possible. Perhaps you’d always wanted to try your hand at trading options, starting a new business or taking a year off from work to be with family. Seizing on an uncommon opportunity is a smart option, but it carries some serious risks.
The risk of seizing an opportunity involves answering two questions: how capable are you in succeeding and is it really an opportunity or just a want? If you have lots of investment knowledge, trading in a new investment may create a low risk opportunity. Using a windfall to open a restaurant when you’ve never worked in food service? You are probably indulging in a want and not an opportunity.
OK Approach: Spend on Something You Always Wanted, but Avoid Income Timing Problems
If you want to spend your money on something you’ve always wanted, that’s up to you and your family, but please do so wisely.
One of the most common mistakes in using income windfalls is not matching the timing of the income to the expense. For example, you get a $10,000 inheritance; time to buy a house, right? Probably, not! If you are taking out a mortgage, you risk overextending yourself. Mortgages are a monthly strain on your budget and your income windfall is a one-time payout. The timing of your extra income is not the same as the timing of the burden of your expenses.
I’m not saying that doing so in this case will lead to doom, but there is a reason why you need a large sum of money upfront for a mortgage. If your ongoing income is enough for a mortgage, it should also be enough to accumulate savings for the closing costs. If you’d never be able to afford closing costs before the windfall, you are probably overreaching on your homeownership dreams.
Use one time income payouts to buy one time payout purchases and regular payout incomes to buy purchases with periodic expenses.
Don’t take out a 30 year mortgage on house, if your new, lucrative consulting contract is only going to last for 5 years. If you are matching a long-term expense with long term income, you still need to be aware of timing. Buying a giant house with a 30 year term, when your current income is only guaranteed for 5 years, could lead you to financial ruin down the road.
While I believe these are smart approaches, they are not necessarily guaranteed or safe. Bad luck is at least as common as good fortune, but at least with a grounded approach you can lower your risks.