How to Invest a Windfall

Sometimes you get a financial windfall—like a gift, inheritance, lottery payout, or a tax refund—and find yourself jumping for joy. But once the dust and excitement settles, you also find yourself wondering what to do with it.

That’s the situation for a reader named Amber W., who asks:

“I’m a full-time student being supported by my parents and they gave me $30,000 more than I need right now. I’d like to invest it and earn some extra money. What advice do you have?”

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Amber’s in a pretty enviable position to have her education paid for by her parents—and to have a lump sum of cash to live on. But unless her parents are willing to keep this gravy train flowing, Amber needs to manage the money wisely.

Here are 5 questions you should ask yourself before you invest a financial windfall:

Question #1: Do I Have Emergency Savings?

Having some amount of emergency money is critical for having a healthy financial life because no one can predict the future. You might have a large unexpected expense or a loss of income.  

Without emergency money to fall back on, you’re living on the edge, financially speaking. So getting a windfall is the perfect opportunity to build up your cash reserves.

I recommend that you keep a minimum of 3 to 6 months’ worth of your living expenses safe and sound in a high-yield bank account that’s FDIC insured. Depending on your situation, you may need more—like if you have a shaky job situation, a large family, or a spouse who doesn’t work.

More: The Best High-Yield Checking Accounts for 2012

What’s the Difference Between Saving and Investing?

Amber asked about investing her excess money. Let’s clarify the difference between investing and saving so you can think strategically about them:

• Saving is for money you expect to spend within the next few years and don’t want to risk losing it. In other words, you save money that you want to keep 100% safe because you know you’ll need it or because you could need it—as with emergency money.

• Investing is for money you expect to spend in the future, like in 10 or more years. Purchasing an investment means you’re exposing money to some amount of risk in order to make it grow. Investments can go down in value; therefore, you should never invest money that you can’t live without.

Though Amber is being supported by her parents, they’re probably counting on her to make her education money last as long as it needs to. My advice for Amber is to save her windfall, not to jeopardize losing any amount of it in an investment.

Once she’s out of school and starts earning her own money, she can begin investing. But until then, her job should be to concentrate on her studies and to develop a career plan.

Question #2: Do I have High Interest Debt?

If you have expensive, high-interest accounts—like credit cards or payday loans—paying down your debt is the next best way to spend a windfall.

Paying off a credit card that charges 22% is like earning 22% on an investment after taxes—that’s hard to beat! So take the opportunity to use a windfall to get rid of high interest debt and stay out of debt going forward.

Question #3: Do I Contribute to a Workplace Retirement Account?

Getting a windfall could be the ticket to increasing your contributions—or to get started if you haven’t been participating in a retirement plan so far. It’s wise to always invest at least 10% to 15% of your gross income for retirement.

Investing through a workplace retirement plan is an excellent way to automatically set aside small amounts of money on a regular basis. A 401(k) or 403(b) allows you to contribute money on a pre-tax basis and invest in funds chosen from a menu of options. You’ll build wealth for the future, cut your taxes, and maybe even get some amount of employer matching.

Question #4: Do I Have an IRA (Individual Retirement Arrangement)?

Don’t have a job with a retirement plan? Not a problem. If you have some amount of earned income (or are married to someone who does) you can contribute to a traditional or a Roth IRA. Even if you do contribute to a retirement plan at work, you can still max out an IRA in the same year—which is a great way to spend a cash windfall.

There are annual income limits on who can contribute to a Roth IRA, but there are no income limitations for a traditional IRA.

More: The Rules for Using a Spousal IRA

Question #5: Do I Have Financial Goals?

After you’ve built up your emergency fund, whittled down high-interest debt, and have money flowing into tax-advantaged retirement accounts, start thinking about using a windfall to make your financial goals a reality. Do you want to buy a house? Go to graduate school? Take a trip around the world?

Use the same principles that I covered earlier: save for the short-term and invest for the long-term. For instance, if you want to buy a car within 6 months or purchase a home within 2 years, don’t invest the money because the value could drop at the exact moment you need it. But if your goal is to send young kids to college or to buy a business in 10 years, that’s when it makes sense to invest a windfall.

More: Investment Tips: How and Where to Invest (the Easy Way)

Unless you get a huge, life-changing windfall, it’s best not to go on a wild spending spree. Instead, use the opportunity to shape up your finances. And if you are lucky enough to receive a fortune, it’s wise to seek professional and legal help to make sure you manage your new wealth as wisely as possible.

Other Articles and Resources You Might Like:

Your Guide to the Roth IRA, Part 1

Financial Advice That Will Make You Rich

25+ Best Personal Finance and Productivity Tools

Checking Accounts That Allow You to Bank the Benefits

Money Girl’s Smart Moves to Grow Rich – get the paperback or ebook!

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