July 13, 2007
Statisticians say the odds of winning the lottery are about the same as being struck by lightning. There are many other, smaller financial windfalls you're much more likely to experience – everything from tax refunds to inheritances to a raise or bonus at work.
The question is: If you do reap an expected or unexpected windfall, what precautions can you take to ensure that extra money isn't just washed down the drain? Here are a few suggestions:
Before going on a spending spree, stash the money in savings until you've examined your total financial picture. Weigh existing debts, upcoming expenses and future needs (like retirement and college savings) to make sure you apply the money where it's needed most.
If you routinely get large tax refunds, you're giving the government interest-free loans. Instead, fill out a new W-4 form to recalculate how much is being deducted with the goal to break even on next year's taxes. It's smarter to put that money to work for you now than to count on a big refund check later.
Pay off debt. Usually the best choice when extra money comes your way is to pay down high-interest debt, like credit cards, a car loan or student loans – although note that student loan interest may be tax-deductible.
Save for emergencies. Experts recommend putting aside three to six months of living expenses in case you lose your job, incur unexpected medical expenses or experience other unplanned events. Put the money in a high-yield money market savings account or a short-term certificate of deposit (CD). You can find competitive account rates at www.bankrate.com.
Save for retirement. Many Americans chronically underfund their retirement savings. One relatively painless strategy is to put part or all of your next raise into an Individual Retirement Account or your company's 401(k) plan. It's easy to have the money automatically withdrawn from your paycheck and the tax advantages these plans offer will make your savings grow even faster.
Finance college. If you've got kids, you're probably already worrying about paying for college. Although your own retirement security should come first (you can always borrow for education, but not for retirement), if you do get a windfall, consider opening a 529 Qualified State Tuition Plan or a Coverdell Education Savings Account – two savings methods that offer terrific tax advantages.
The U.S. Securities and Exchange Commission's website has information on 529 plans (www.sec.gov/investor/pubs/intro529.htm) and the IRS's site explains Coverdell accounts (www.irs.gov/taxtopics/tc310.html). Another website, www.savingforcollege.com, discusses these and other education financing methods.
Budget. Once you've used your windfall to pay off debt or start a savings plan, don't slip back into bad habits. Practical Money Skills for Life, a free financial management site sponsored by Visa Inc., features an interactive tool called My Budget Planner that helps you track income and expenses so you can save for long-term goals like buying a home, getting a new car or paying for college. Go to www.practicalmoneyskills.com/mybudget to download.
As always, consult a financial professional regarding your particular situation. And don't forget to reward yourself for having the discipline to use your financial windfall wisely. I like the 90/10 rule, where 90 percent goes for debt payoff or savings and 10 percent is to splurge on something fun.
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