CHAPTER
19

Managing Windfalls and Sudden Life Changes

In This Chapter

• Evaluating your new spending power
• Taking steps to protect yourself
• Sorting out spending priorities
• Considering long-term needs

Experiencing a sudden life event, whether thrilling or devastating, that significantly alters your expectations for the future can be extremely destabilizing. You may feel confused and unequal to the task of managing your new financial state, and everyone you’ve ever known will have advice for you.

In this chapter we look at how to evaluate the financial challenges, get trustworthy advice, and sort through the possibilities of how to manage your money.

It’s important to manage sudden money for growth, not to go on a spending spree. It’s very hard, especially if you’re new to the game, to avoid feeling like Now I can buy anything. Any level of wealth still requires choices and plans. You want to view this sudden lump sum as seed money to sustain and grow your wealth. You do not want to blow it and end up back where you were, or worse.

Do not rush into anything. Don’t pay off anyone’s loans, put a down payment on a house for a relative, rush out to buy a car, or take the whole clan to a four-star resort. You must establish an overall plan and understand just how all the parts will interlock, before you—well, there’s no better word for it—squander your money.

Assembling Your Team

Begin by assembling a team of professionals with whom you can consult. You’re going to need the following:

A financial adviser See Chapter 9 for a discussion of choosing an adviser. A fee-only fiduciary adviser can help you walk through issues of spending, debt repayment, planning for the future, and charitable giving. A financial adviser can act for you the same way an internist takes care of your health: looking at the big picture, working on specific issues, and referring you to reputable specialists for help in specific areas.

A Certified Public Accountant (CPA) and/or tax attorney You need to understand what taxes you must pay, what your actual net will be, and whether there are any strategies you can use to lower the bill. There’s not necessarily any magic wand they can wave to eliminate taxes, but they can help you pay as little as possible. This person should work in conjunction with:

An attorney who focuses on estate planning Hardly a month goes by without a news story about a famous person who either died without a will, or failed to update it when family circumstances or their own wealth changed dramatically. While I’m sure the IRS does a happy dance every time this occurs, you should take more control over your money. An estate attorney can prevent your private details (and those of your heirs) from being splashed all over the internet, as well as structuring some prudent control of your heirs. They can plan trusts that minimize estate taxes, and structure charitable bequests.

A psychologist If you’ve experienced a significant psychological loss through death or divorce, or even a positive event that changed your life, it helps to talk to an experienced third party who can help you work through your feelings. Even if the event was anticipated or welcomed, you’re going to have emotional fallout. Also, a psychologist is probably going to be way less expensive than getting “counseling” from your lawyer or financial planner, who aren’t qualified to help you in this area anyway.

A business attorney (possibly) You may want to consider the possibilities of establishing a corporation or foundation, both for tax and for privacy reasons (if the windfall is large).

Lest you think I’m only offering advice for lottery winners, let me point out that, with the exception of the business attorney, a divorced or widowed person is going to need this team as well. You want to make your money last (whatever its size), be sure you understand your tax picture, and be certain you have an updated estate plan.

Give yourself time to think, recover, and look forward. A divorce or death can fell us with grief and indecision. Nothing seems certain in a world that is not as we knew it. You may feel as if you don’t have a life anymore. You do have a life, just not the one you expected. Your plans must change, but with those changes come possibilities.

Choosing Between a Lump Sum or Structured Settlement

In some cases of windfalls, you’ll be offered the choice between a lump sum payout or a structured settlement that pays a portion each year. These offers are common in cases of personal injury awards or lottery winnings. If you’re offered these choices, you should consult a financial adviser to work through your individual needs and options.

Here are some considerations you should address:

• If you were to choose the structured settlement, how guaranteed is it? Is it guaranteed by a highly rated insurance company (equivalent to a first-class annuity) or is it dependent on appropriations by the legislature (as for Illinois lottery winners)?
• Will your money grow with inflation in the payout, or would you be better off growing a lump sum in a diversified investment portfolio?
• If you took a lump sum, do you have a plan for preserving the money and fending off the temptation to overspend?
• Do you have the experience and expertise to manage a large sum of money (with expert, reliable advice)? Have you ever managed a large sum before?
• Have you investigated the tax consequences of the possible choices?

Please see the discussion in Chapter 15 on pensions and annuities. You’re facing most of the same issues—finding ways to ensure that your money lasts a long time, keeps up with inflation, and doesn’t incur too much risk.

Thinking Through Your Spending Priorities

Whenever we plan investing, we must also consider spending needs. Whenever there’s a sudden influx of money, most people consider debt repayment, helping out friends and relatives, and paying off or buying a house as high priorities.

The financial answer hinges on the interest rate you’re paying, and how high the debt is in relationship to your income. If you have a low interest rate and have been paying on time, there’s no real reason to rush to pay off the debt; you’re probably going to be able to earn more by investing.

Let’s say you have student loan debt of $50,000 at 3.5 percent interest. You earn $60,000 a year in salary. Should you pay off your loan? Probably not. It’s a low enough amount at a low enough interest rate that you would be better off (by the numbers) investing your money in a diversified portfolio.

But what if you owe $200,000 at 6 percent and you still earn the same $60,000? Here, the monthly payments have probably been a struggle, and the interest rate is high enough that a conservative investment portfolio probably won’t exceed it by a lot. Here, it begins to make sense to pay off the debt.

In the preceding example, if $200,000 represents the entirety of your windfall or inheritance, you’re going to need to consider your overall financial picture. Are you young, with the possibility of earning more and building savings? Are you near retirement with not enough to live on? If the debt were paid off, have you changed any spending habits so that new debt won’t be acquired? These are all behavioral and psychological issues as well as financial ones.

If paying off debt would only open the door to new spending, then you’re probably better off creating a disciplined plan to accelerate repayment but moderate your spending. If the debt is keeping you up nights, destroying family relationships, or making you feel hopeless, then these issues trump any number crunching. Once you get expert advice, the best use of the money might be debt repayment.

Should You Pay Off Someone Else’s Debt?

What if it’s someone else’s debt you’re thinking of paying off? Here, you should evaluate the idea much like any other investment: what’s the risk, what’s the reward, and does the investment have a reasonable chance of being profitable?

If someone in your life has dug themselves into a financial hole by unwise spending, poor financial choices, or a peripatetic employment history, think carefully. The idea that we can solve someone’s problems with one action is very romantic and appealing. However, I urge you to consider the other person’s behavior. Saving someone without any participation by them often produces the opposite result the giver intended: the recipient can feel demeaned, powerless, or free to repeat the behavior that brought the trouble in the first place.

I recommend that you make your recipient responsible in some way for the gift. For example, you might give the gift once they have paid off a certain level of debt themselves, or performed specific services for you, or agreed to repay you over a structured period of time (with consequences if they don’t).

Maybe you’re thinking about buying your kids a house or paying off their school loans. Here, you have to know your kids, and make some judgment about the effect such a gift might have on their motivation in life and their own relationships. One person with money can really drive a wedge into a marriage. Of course you love your child, but you don’t want to take away their pride in standing on their own two feet. On the other hand, helping a hard-working child, investing in their business, or starting a college fund for the grandchildren may be exactly what you’d like to do with a windfall.

The most common scenario is a parent giving their adult child some money for a house, with a handshake agreement that “you’ll pay me back when you can.” The adult child then gets a divorce and in court the other spouse will almost certainly claim that the money was a gift to the couple (marital property) rather than a loan (marital debt obligation). Not only will the money be gone, but the ex-spouse will benefit by it. It’s ugly, and happens routinely.

If you’re contemplating paying off your partner’s debts, see a family law attorney for advice on how to document the terms of that repayment, and what would happen to the money in the event of death, disability, or divorce. It may never happen, but if it does it will save you a lot of legal fees wrangling over it in the future.

What to Do About the House

The comments above about paying off debt also apply to the decision to pay off your mortgage. However, it’s even more important to consider your other circumstances. You don’t want all your money invested in your house, especially if you’re close to retirement and need income. A house generates no income and in fact costs you in maintenance and taxes, even if you pay off the mortgage.

For this reason, divorced people should think very carefully about the house. In a divorce, people will fight to keep the house, especially if there are children involved. The reasoning goes something like this: “The kids already have enough disruption in their lives. I don’t want them to have to change schools. They’re afraid of losing their friends.”

If your children are young, they’ll adjust (and you should invest in psychological help if possible to assist in the process). If they’re older, they’ll probably be in college in a few years, and then you’ll be stuck with a big, expensive-to-maintain house. Life will go far better if you’re not stressed out by the cost of the house and the burdens of maintenance. I often tell people going through a divorce that if they really hate their spouse, they should give him or her the house, and take the investable cash for themselves.

For widows and widowers, you probably have a house filled with memories, but you must consider whether you can really keep up with maintenance. Do you have children or family who can help? Can you pay for any services you might need? Would you be more secure and less stressed in a different living arrangement? The most tragic scenario is the spouse who can’t let go of the memories of the happy years in the house, but who becomes increasingly feeble, with little cash flow. When they need care, they can’t afford to pay for it without selling the house.

Let’s look at the flip side: you suddenly have enough money to buy the house of your dreams. Should you? Maybe, but not until you’ve scoped out your entire situation with your team of advisers. Moving, even when it’s to something better, is still a stressful activity. You don’t want to change your life radically without some thought and investigation. Would you like the new neighborhood or location? Maybe you should consider renting in the locale first. You might find you actually don’t like Paris, or Key West, or Maui as much as you originally thought. If you do, you’ll have a much better sense of the market and the right neighborhood after you live there a while.

I was once a Realtor, so I’m going to give you another piece of advice: don’t upsell yourself. In all my years selling real estate, people always bought the maximum they could afford. Any little flaws in the cheaper properties could always be overcome by just spending more. If you don’t have more, you won’t be able to spend more and will content yourself with what’s available to you.

In almost any price band, what would be a palace to me might be a cottage to you. Set yourself a maximum purchase price based on your overall financial plan, and tell the Realtor your top price is 10 to 20 percent less than that. You’ll have some room to upgrade, but you won’t be tempted beyond your prudent initial decisions.

Changes to Other Plans

Any change in financial circumstances is going to require a new look or reevaluation of any goals you had before the change.

Saving for College

If you receive a large windfall, you’re going to have to face the fact that you can’t qualify for financial aid. If your children are still years away from college, consider sheltering the earnings on some of your savings by prefunding 529 plans for college (see Chapter 17). You can contribute up to 5 years’ worth of your gift allowance (5 × $14,000) per parent for each child. The money then grows tax-free (and you can do it again after 5 years).

Depending on the exact nature of the money (if it’s an inheritance, for example, instead of royalties, which are income), you might be able to systematically transfer money into a Roth and/or maximize your 401(k) contribution if you’re not already doing so. These plans require you to have earned income (below a specific level for the Roth), but you don’t necessarily have to write the check from that income—you can use funds in a taxable account to transfer to the Roth (or increase your deductions at work but withdraw a little more money to live on from your windfall investments). It may not make you qualified for financial aid, but at least you’ll be sheltering earnings and can use the Roth for college costs if needed.

But what if you were on track for college savings, but now, because of divorce, aren’t able to continue to save?

Although everything is negotiable in a divorce, courts generally agree that the money in 529 and Coverdell plans belongs to the child and is not joint marital property. The difficulty can come when one spouse is the owner for the child beneficiary (as is usual in these plans). Unless there is an agreement in the divorce decree, there is nothing to prevent the spouse-owner from cleaning out the plan, paying the tax and penalties. Try to secure an agreement that this cannot be done.

No one should jeopardize their retirement in order to pay for college. If you would have to withdraw from retirement funds or emergency savings in order to cover college costs, you need to retool college plans. Either the children will need to go to a less expensive college, or borrow more money, or work for a time to accumulate money, or some combination of the above. Yes, a parent is going to feel terrible delivering this news, but it’s not a cataclysm. Much of life requires making a choice, not among the optima but among the least bad choices. And then making them work.

Depending on state law, a parent paying child support may have no legal obligation after the child graduates from high school or turns 18. This is negotiable in a divorce settlement. However, even if the parent is not compelled to pay for college, the income will still be considered as part of the financial aid determination by many private schools (using the CSS/Profile financial aid evaluation). Let’s say the mother has an income of $50,000 per year and no assets except the house (probably qualifying for financial aid). The father has an income of $200,000. Because his income is probably too high to qualify for aid, the child may not get any financial aid even if the father refuses to contribute a dime.

It is very difficult to get an exemption from having both parents’ income evaluated for financial aid by private schools. It will generally require documentation of serious reasons (history of physical or sexual abuse) why the child has no contact with the parent, and why the parent will not or cannot pay. Be prepared with evidence from attorneys, psychologists, and law enforcement. It’s going to require a big investment of time to accomplish this.

(Early) Retirement

Can you take that job and shove it? Depends on the size of the windfall, your age, your current portfolio, and your spending needs. You’re going to need those advisers to calculate what’s left after taxes, how many years you can expect to live in retirement, and how to invest the money so it beats inflation. You can really start to consider handing in your resignation if your windfall is in the seven figures.

On the other hand, a publicized windfall (like the lottery) may make it very uncomfortable for you to continue in your present job. Even a smaller inheritance may have you dreaming of making tracks out of there. This is a terrific time to consider retraining, upgrading your education, or taking a time- and money-limited sabbatical to explore a new career, a new location, or a new workplace. Get a referral to a professional career counselor and use some of your money to get the best advice to help you make a plan.

Death of a Spouse

Losing your spouse may mean that you have to reenter the workforce. A career counselor, particularly one who focuses on second careers and job changers, can be a real help in repackaging your résumé in more current terms, coaching you to present yourself in the best possible manner, and suggesting retraining opportunities that you may not have considered.

Be sure to collect all the Social Security benefits to which you’re entitled. If your deceased spouse had a higher benefit than you, you can switch to that full amount as a survivor’s benefit. If you are divorced, have been married at least 10 years, and have not remarried, you are entitled to spousal benefits as if you were still married, and survivor’s benefits if you did not remarry before age 60.

You may find yourself in a situation where your inheritance or settlement comes to you already invested in a complex portfolio that you neither understand nor feel capable to manage. You’re going to need study and advice for this one. Be sure to read the basic information in this book to get you started on asking the right questions, either for further reading or for a fiduciary adviser.

Too often, the custodial parent will say, I’ll keep the house and you can keep your retirement account. This is usually not an equitable division. A Certified Divorce Financial Analyst (CDFA) can help you understand why by showing you projections for the relative growth of any proposed settlement. You may find out that while the house owner and the investment account owner start off in relatively the same place, the investment account owner will end up in a far better financial condition in 10 or 20 years due to the difference in investment growth.

If money is to be transferred, be sure you have a solid agreement as to not only the amount to be transferred but also the timetable by which the transfer is accomplished. Plenty of people sign divorce settlements without understanding how a 401(k) will be divided, how the transfer will be accomplished, by when, and what paperwork is needed. In the case of retirement plans and pensions, a Qualified Domestic Relations Order (QDRO) will be required to move funds. You should also be certain that the order makes provisions for how the settlement will be handled if one person dies before the order is completed.

Remember that just about anything in a divorce ends up being negotiable, particularly if one person is determined to bleed the other person by continuous legal fees. Most courts will not even consider the financial division until a plan for care and custody of the children is agreed upon. The less wrangling you do, the less time and money will be spent on attorney’s fees.

As with all situations involving financial transactions, you need to make every effort to keep in calm control. You need to understand your attorney’s plan for accomplishing a settlement, and the strategy for doing so. A reputable attorney can work with you on a realistic timetable and what the alternatives are likely to be. More than one person has felt that their attorney has accomplished very little for the hours billed; if this is the case, you need to demand accountability.

On the other hand, attorneys’ biggest complaints are that the client has failed to produce the necessary expense reports and other data, has not listened to reasonable advice on settlement, and though things have been explained multiple times, the client hasn’t paid attention.

If you don’t understand, keep asking (and requesting meetings) with your attorney until you do. The money spent to understand and team up to pursue a strategy should ultimately save billing hours. Recognize that you may be rattled, and bring your financial adviser or perhaps even a trusted friend along if you cannot understand on your own.

While divorce proceedings are going on, you must get a grip on yourself and think through the issues that will confront you after the divorce. Now is a great time to read some books or take some classes on investing. If you must return to work, don’t wait until the divorce is settled—begin as soon as possible. Too often people who have been out of the workforce wait until the divorce is final to begin looking for a job or retraining, in the belief that this will make them look more pitiful and more deserving of support to a judge. Not so. In modern times, the courts expect that each party will do what they can to make themselves independent and self-supporting.

No one comes out of a divorce as wealthy as when they were a couple. At a minimum, two households must now be supported instead of one. But neither is a divorce necessarily a hopeless condemnation to eternal poverty. With a solid financial plan, steps taken for emotional recovery, and judicious management of investments, people can and do recover.

The Least You Need to Know

• Take your time to learn to cope with the initial shock and stress of finding yourself in changed financial circumstances.
• Assemble a team of reliable fiduciary advisers to help you make a plan to manage your money wisely.
• Think carefully about paying off debt with your windfall. Be sure it makes financial and psychological sense in your circumstances, and get the agreement in writing if you’re paying off debt for another person.
• Divorce has an impact on all your plans: housing, income, retirement, college financing. Manage your emotions, and get expert advice.
• Realize that your life has changed and your now-different financial possibilities and challenges may affect the goals and plans you had previously formulated.
• Balance some prudent spending to achieve goals with preserving the bulk of your windfall to continue to serve you long term.