Navigating the Opportunities, Challenges and Pitfalls of Sudden Wealth
The term “sudden wealth” refers to receiving a large financial windfall. Most frequently sudden wealth comes from an inheritance, but it can also be the result of selling a business, reaching a legal settlement or (much less often) winning the lottery. While the advantages of becoming suddenly wealthy are obvious, less obvious is the planning that must take place to preserve that wealth. Without the proper planning strategies in place, it’s not uncommon for individuals to quickly lose their wealth to overspending, taxes and/or unintended financial obligations. In fact, due to making financial mistakes managing their money, approximately 70% of lottery winners lose or spend their entire sum of winnings in five years or fewer.1
Read on to learn several common mistakes made by those with sudden wealth — and how you can avoid them.
#1 – Making hasty decisions
Receiving a financial windfall can be an emotional experience, especially if it’s the result of losing a loved one. You may go from feeling exhilarated to feeling worried, sad and guilty. This is normal and to be expected. However, these emotions often lead people to make hasty decisions they later regret. The best course of action immediately after receiving a large sum of money is to not spend it — at least not right away.
It’s wise to wait at least a few months, if not an entire year, before making any major purchases. This will give you time to put a plan in place, understand your tax liabilities and prioritize your spending.
#2 – Failing to plan
A big mistake people make after receiving sudden wealth is failing to plan for the future. It’s absolutely vital to incorporate these new assets into your overall financial plan. Work with your wealth manager to reassess your goals and figure out what needs to be done. Consider how the following should be adjusted to account for your financial windfall:
- Estate plan and beneficiaries
- Retirement savings and income plans
- Investment portfolio
- Insurance and other risk management strategies
- Tax planning and reduction strategies, including charitable planning
#3 – Forgetting about taxes
Receiving a large sum of money can land you in a complicated tax situation. If not properly planned for, taxes have the potential to quickly erode a large portion of your windfall.
Different types of sudden wealth are subject to different tax liabilities. For example, lottery winnings are taxed as ordinary income and can push you into a higher tax bracket. In contrast, inheritances are not considered income but may be subject to both federal and state estate tax. If you receive an IRA, any withdrawals are taxable as income, whereas an investment account of stocks, bonds and real estate may be eligible for a step-up in tax basis.
Sound complicated? It can be. The best course of action is to work with a qualified CPA who can help mitigate your tax liability and preserve your wealth.
#4 – Spending far and wide
It’s not uncommon for those who receive a large financial windfall to begin spending on everything they’ve ever dreamed of. While there’s nothing wrong with having a little fun with your money, too much spending can quickly deplete your new wealth.
Take time to prioritize your spending, focusing on the areas most important to you. While they may not be the most exciting expenditures, you should take care of the following before spending on “fun” purchases:
- Pay taxes
- Reduce debt
- Save for retirement
Once these expenses are covered, work with your wealth manager to develop a spending strategy for your other financial priorities.
At Creative Planning, our teams help clients navigate the opportunities, challenges and pitfalls of sudden wealth. We enlist the support of our in-house tax advisors, insurance professionals, investment professionals, estate planning attorneys and more to help manage and preserve your assets. If you’d like help managing a recent financial windfall, schedule a call with a member of our team.