What to Do with an Unexpected Bonus or Windfall

While sudden windfalls such as bonuses from work or financial gifts may provide a golden opportunity for improving your financial situation, there are several things you need to know before you begin allocating or spending the funds. From tax implications to figuring out whether you should pay down your debts, there are hurdles you’ll have to clear on your path toward meeting your financial goals.

In this article, we’ll outline the basics of what you should do in the event you receive an unexpected bonus or windfall. Note, however, that this article only provides general information about your options for investing, spending and saving your money. If you need a specific strategy for how to divide up your funds, you should always speak with a financial professional who can review your finances and suggest a course of action that meets your unique financial needs.

Understanding the basics of receiving unexpected money

When you receive a sudden windfall such as a bonus, inheritance, legal settlement or gift, there are a few important tasks you should complete before you even think about what to do with the money. Especially for smaller amounts, it can be tempting to use the money immediately for vacations, shopping and other expenses but moving too quickly could harm your finances by leading to unforeseen taxes and other complications.

Set some of the funds aside for taxes

Start by making a note of where the money came from.

Was it a large bonus from work? Did you receive a settlement from an insurance claim? Were you a beneficiary on someone’s retirement account?

The origin of the money will directly impact whether you need to pay taxes on the funds. In most cases, gifts and inheritances aren’t taxed by the IRS or state governments (with some notable exceptions). Meanwhile, the IRS considers most work bonuses to be supplemental income, meaning you’ll have to pay taxes on them.

When you receive the money—no matter where it came from—you should always take a moment to figure out your tax obligations. Taxes can be complicated, and you don’t want to spend or invest the money before you figure out if you owe a large amount of taxes on the funds.

For larger amounts, it’s highly recommended that you speak with a tax professional as soon as possible so you can set aside any money you may need to cover any taxes at the end of the year.

For smaller amounts, you should try to set aside around a quarter to a third of the money (depending on your tax bracket) if you believe that you’ll have to pay taxes on it at the end of the year.

Respect the money’s potential for growth

After you set aside some of the money for taxes, you’ll be left with an amount of post-tax income that you can spend and save however you’d like. This is where temptations such as vacations, new cars and spending sprees have the highest chance of draining your windfall’s value.

To be clear, you should think very carefully about how and where you’ll spend or save your newfound money and how that’ll impact your overall situation both short and long term.

Receiving a sudden bonus or windfall is a rare chance to improve your financial situation quickly and significantly. For example, an investment of $50,000 today at a 6% rate of return would result in an account worth $160,000 in 20 years due to the effects of compound interest. Similarly, putting a small work bonus of $3,000 toward your mortgage’s principal could end up saving you thousands of dollars in interest over the life of the loan.

The point is that when you look at the money you have today, you should consider both its current value and its potential for future growth. A dollar today can be worth several dollars in the future, provided you save it someplace it can grow. That’s not to say you should avoid spending your windfall on yourself or your family. In fact, it’s common for financial experts to recommend spending around 10% of the bonus or windfall on “wants” and other celebratory purchases. However, it’s wise to put most of the funds toward things that can improve your financial situation in the long term.

Consider a few financial planning strategies

After you set aside money for taxes and carve out a small amount of money to spend today, you should take steps to secure your financial stability in the future. Often, this means building an emergency fund, paying off any high-interest debt, investing the money in a tax-advantaged retirement account and making progress toward any other financial goals you may have.

Prioritize improvements to your financial situation

As you begin planning for where the money will go, you should list all your financial goals in one place to help you prioritize your spending.

As a few common examples:

• Build an Emergency Fund — You can build an emergency fund that can cover around six months of your living expenses. You should keep this money in either a savings account or another account with low risk and high liquidity.
• Erase or Pay Down Your Debt — You can also work to eliminate any debt with an interest rate higher than 8-10%. By paying down this debt quickly, you’re effectively getting a guaranteed return on your investment equal to the interest rate of the debt. Debt at a lower interest rate (such as a mortgage) is generally less of a priority because you can make more money on average through investments. However, if your goal is to become debt-free as soon as possible, then peace of mind and guaranteed returns of paying down debt might outweigh the missed opportunities elsewhere.
• Max Out an IRA — You can save your money in a tax-advantaged retirement account such as a traditional or Roth IRA. As of 2023, the contribution limit for these accounts is $6,500 per year (or $7,500 if you’re over the age of 50). If you still have money left after making your annual contribution, research whether you still have time to contribute for the prior year. You may also want to save some money to make a bulk contribution at the beginning of next year.
• Contribute to an HSA — A health savings account (or HSA) is a tax-advantaged healthcare savings account available to individuals with high-deductible health plans. You can put money into the account tax-free and then withdraw the funds for qualifying healthcare expenses without incurring any taxes. The HSA contribution limit for 2023 is $3,650 for individuals and $7,300 for families (with an extra $1,000 catch-up contribution on top of either limit for those 55 and older). Much like IRAs, HSAs are a great way to save money in taxes by lowering your taxable income, making them a great place to store any unexpected bonuses or windfalls.
• Save for Retirement in Other Ways — Outside of IRA, HSA and other contributions, you may want to consider other options for improving your financial situation long term. For example, it may be beneficial to pay down any moderate-interest debt (with a rate of 5–7%) or to invest the funds into a regular investment account. Minimizing your expenses by eliminating debt or maximizing your returns by contributing more to an investment account can set you down a path toward a long and comfortable retirement.
• Consider Alternative Investments — Finally, it’s worth noting that investing in the stock market isn’t the only way to improve your financial situation. In cases where you receive a significant windfall (of six digits or more), it may be worth your time to research alternative investment strategies such as real estate to diversify your portfolio. Note, however, that these investments tend to carry more risk, so it’s wise to consult with a financial advisor before you pursue any alternative strategy.

Financial priorities in practice

Once you make your list of financial priorities and order your list from the most to least important to you, plan out a strategy for exactly where each dollar will go. For example, let’s say you receive an inheritance of $50,000 from a beloved family member and you owe no taxes on this amount. In this example, you build out an emergency fund of $20,000 to cover six months of your household’s expenses, leaving you with $30,000. Then, you owe $20,000 on high-interest debt, so you decide to pay that down, leaving you with $10,000. Since you haven’t maxed out your IRA for this year yet, you deposit $6,500 into your Roth IRA, leaving you with a final amount of $3,500. With no pressing financial goals left you decide to put the rest into your HSA where it can grow and be invested tax-free.

Notice how the flow of the money in this example follows the list of priorities outlined above.

In the same situation but with an inheritance of $30,000, you could make a $20,000 debt payment and a contribution of $10,000 to your emergency fund.

Put another way, in the event you receive a bonus or windfall your spending should waterfall from one category to the next until you either fulfill all your financial goals or run out of money. In doing so, you can make the greatest impact on your financial health by focusing on the areas with the greatest potential for improving your financial security before moving on to other strategies.

Consult with a financial advisor

The strategies and examples outlined in this article are simply general information meant to help you understand some of the options you have available for managing your bonus or windfall. Remember, it’s impossible for anyone to provide guidance or advice on what you should do with your money without first reviewing the specifics of your financial situation.

In the event you find yourself the beneficiary of an unexpected windfall, the best first step you should take is to speak with a financial advisor with a fiduciary duty to put your interests first.

From understanding the tax implications of your windfall to helping you prioritize certain aspects of your finances to improve, it’s critical that you partner with a trusted professional who can help you find the best path toward meeting your financial goals.

From opening IRAs and other accounts to helping you with your financial planning needs, our experts are happy to assist you in creating a plan to grow your wealth.

If you’d like to speak with an experienced professional about the options available for growing your windfall, please feel free to give us a call at 800-236-8866, schedule an appointment online or stop in at any of our Associated Bank locations.