Illustration by Christoph Niemann
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Taking Your Lumps
By Diane Harris, September-October 2003
A severance package, a pension payout—even an inheritance—can feel like pennies from heaven. But don’t blow it!
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You've just received a big, sweet pile of money. Enough to live comfortably for months, or years—or to finally buy that new home, or spend two weeks in
Pebble Beach, or pay off your absolute last dollar of debt. Maybe the cash is part of a severance package or a pension plan distribution. Maybe you've sold a house and made a nice profit. Maybe it's from a life insurance policy or divorce settlement—or your share of the $10.4 trillion that baby boomers will inherit from their parents in the next few decades.
Whatever the source, that windfall can be a breath of financial fresh air.
For too many people, though, the relaxation is short-lived. NBA rookies and hip-hop stars aren't the only ones to find themselves inexplicably broke a short time after they've raked in enough greenbacks to seemingly keep them flush for life. It's all too easy to fritter away a large sum if you don't have a plan.
"Lump-sum payouts typically constitute more money than most people have ever seen at one time in their lives, and the opportunities seem limitless," says Deena Katz, a certified financial planner in Coral Gables, Florida. "But if you're not careful, you can easily blow it, through a combination of bad advice, poor planning, taxes, penalties, impulse buying, and old-fashioned but usually misguided generosity to family and friends."
If there's a lump sum in your life, here are the steps you need to take to manage it wisely.
Park it for the season
Lump-sum payouts are often associated with highly emotional events, such as a death, a divorce, or being laid off from a job. Consequently, you're probably in no shape to make big financial decisions.
"When people receive a lot of money, they often have an itchy trigger finger to invest it—they're in a rush to act," says Ann Perry, author of The Wise Inheritor (Broadway, 2003). "But you need a period of contemplation and soul-searching, so you can figure out how your life has changed and what you need this money to do for you."
That's why most financial advisers recommend stashing your lump sum in a safe, easily accessible place, such as a money-market account, a short-term CD, or even an ordinary interest-bearing bank account, for six months to a year. You won't earn much during that period, but you won't lose a dime either or lock your money into poor investments. You can still tap the account to cover your current expenses, and you'll gain valuable emotional breathing room in which to devise a sound, long-term financial plan.
If the lump sum isn't in the form of cash—say, it's a distribution of stock or mutual funds from a pension or profit-sharing plan—you can simply leave it with the company. Likewise, don't sell any securities you inherit until you've had time to research their merit and their growth potential. "The money won't burn a hole in your pocket if essentially you elect to do nothing with it for a few months," says Katz. "To choose to do nothing is a course of action, too."
Turn a deaf ear to your "advisers"
Ignore the well-meaning advice of friends and family about how to manage your newfound money; what could work well from their standpoint may be wrong for you. Ditto the hard-sell tactics of bankers, brokers, and others who may bombard you with cold calls.
"Every stranger is your friend after you receive a large sum of money, and when you're going through a hard time emotionally, it's easy to respond to empathy and a promise that 'we'll take care of you,' " notes Katz. "They have their commissions, not your best interests, at heart."
Don't reenact The Millionaire
It's tempting to make large cash gifts to adult children or your siblings, or other relatives and friends. Especially if one of them is particularly deserving and needy. But don't do it—at least not right away.
"One of the biggest mistakes people make when they receive a large amount of money is to be overly generous and try to solve other people's financial problems, especially those of their adult children," says Sue Stevens, who is director of financial planning for Morningstar, Inc., the investment research company in Chicago. "But what seems like a lot of money upfront may turn out to be peanuts if you need it to last the rest of your life." She adds, "There's almost always time in the future to give money away, but no graceful way to get it back if you need it, once the gift has been made."
Give that cash a goal
Think about your financial needs and aspirations, and how this money fits in with other savings. Do you need this cash to cover immediate living expenses for yourself and your family—permanently or until you find another job? Or is this the nest egg you're counting on to see you through retirement? Are you hoping to use at least some of the money to pay tuition bills for your children or grandchildren, or to leave to your family after your death? The answers to these kinds of questions will dictate your best investment moves.
See a specialist
Get the help of a financial pro who can help you sort through all the choices for using your lump sum. Importantly, you want input from an objective financial adviser who specializes in your type of distribution. Whether it's a one-time consultation or you're signing up for ongoing advice, choose an expert who works for a fee only—not one who earns commissions every time you invest in one of the financial products he or she is selling.
You can find local advisers in your desired specialty who provide services on a fee-only basis from professional groups such as the Financial Planning Association (800-647-6340); the American Institute of Certified Public Accounts, Personal Financial Specialist division (888-999-9256); or the National Association of Personal Financial Advisors (888-FEE-ONLY).
Let the professional deal with the details
"The rules governing some types of lump-sum payouts are extremely complicated and change as often as the tax laws do," explains Thomas Gau, a certified financial planner and accountant in Ashland, Oregon, who specializes in retirement distributions. "If you're not careful, you could end up losing a big chunk to taxes and penalties."
Consider what might happen if you inherit an IRA from someone other than your spouse. If you cash out the account, you'll obviously owe taxes on the entire amount. But if the original owner of the IRA specifically listed you as the beneficiary, a better option may be to convert the IRA into a "stretch IRA" and to spread out the distributions over a period of years. That will enable you to postpone taxes on the bulk of your inheritance and continue earning tax-deferred profits.
But it's not that simple. If you don't begin taking those distributions by December 31st of the year after the owner's death, for example, you may be forced to cash out the entire amount within five years. Further, if you fail to take out the minimum amount required annually, you'll be nailed with a penalty tax equal to half of the shortfall.
Complicated, huh?
It gets worse. Say you take a lump-sum distribution from a 401(k), pension, or profit-sharing plan from your employer. If you decide to take a check instead of having your old employer immediately roll the funds over into a new IRA, the employer will be required to withhold 20 percent of the total for taxes. Within the next 60 days, you'll have to put 100 percent of the lump sum in a new IRA—and that means you'll need to make up that 20 percent out of your own pocket. If you can contribute the extra cash, the IRS will refund it to you later. But what happens if you don't have the ten, twenty, or perhaps forty thousand dollars or more to make up that withheld money? You'll owe Uncle Sam taxes on the outstanding amount. Nothing can kill the euphoria of inheriting a lot of money faster than wading through tax laws.
To avoid running afoul of such rules and owing the government large penalties as a consequence, consult a tax adviser who specializes in these areas—in addition to any general financial planner you may already use. "You wouldn't see a general practitioner if you needed brain surgery," says Gau. "Give your finances the same treatment."
Spread it around—slowly
Most financial planners believe your best bet is to invest a lump sum slowly over time—say, a year or so—and to spread the money among a few different kinds of securities, so you're not caught short by unexpected reversals in investment fortunes.
That's particularly true for older investors who have less time to recover from market setbacks and for whom the lump sum may represent the best—and last—chance to reap the investment returns that will lead to a financially secure retirement. "You don't want to take a lot of risks when you're investing without the safety net of time," says Katz. "Don't worry about where your lump sum will earn the most money; just focus on earning enough on your investments to reach your goals."
The specific investments you pick will depend on your particular situation, but the same general rules apply to lump-sum investing as any other kind. Following are three guidelines many experts recommend based on when you'll need to use the bulk of your money:
1. You need the cash NOW. Keep the money in something safe and accessible, such as a money-market account.
2. You'll need it within three to five years—say, for a child or grandchild who'll be heading off to college soon or for that retirement condo in Florida you've been hoping to buy. Consider investing the money primarily in conservative, interest-bearing securities, such as short-term and intermediate-term bonds and bond funds.
3. If you can sit on it for five or 10 years, and allow that cash to grow, you'll probably want a mix of conservative growth stocks and income-oriented investments such as bonds.
Don't get sentimental for a stock
After researching them, dump stocks, bonds, and other non-cash securities that don't fit into your overall portfolio. Importantly, don't keep stocks that you inherit only out of respect for a loved one who's passed away. You do no one any good by holding on to losers or prospective losers. "It's okay to be sentimental about the ratty sweater your husband wore on Saturday night to smoke his pipe," says Katz. "It's not smart to be sentimental about his shares of AT&T."
Splurge. At least, a little
Carve out a small portion of the lump sum for a special purchase or personal treat—what author Ann Perry calls "a righteous splurge"—that allows you to make emotional peace with the fact that you've just received a significant amount of money without blowing the lion's share of it frivolously.
Perry speaks from personal experience. Raised in middle-class circumstances, she was surprised to learn after her mother died several years ago that the value of her estate would come to about $500,000, after a house and other assets were sold. The inheritance allowed Perry and her husband to buy a larger home and invest for their two sons' college educations as well as their own retirement. Her most cherished purchase, however, was a brand-new $23,000 minivan that she paid for in cash. "My mother had been ill for a long time, I was the primary caretaker, and I wanted to help my family heal after many months of emotional trauma," Perry recalls. "The idea of a van for family outings seemed to fit the bill." She adds, "I think my mom would have approved."
Diane Harris specializes in personal finance and is the co-author of It Takes Money, Honey.
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