When it comes to windfalls, there are those rare occurrences that many of us dream about, like achieving a six-figure bonus at work or winning the top prize in a professional golf tournament. Then there are others that seem more likely: for instance, many Americans inherit sums of money from older relatives, and the majority of us get tax refunds in some of our working years.
Even a modest infusion of money can do a lot: in 2014, the average refund from the IRS totaled $3,034. This kind of cash influx can yield lasting value if applied to a pressing financial need or future goal instead of the pleasure of a shopping spree or vacation.
You can put a tax refund, or other newfound wealth, to work in a number of ways. Some ideas include:
Build an Adequate Emergency Fund
As the first step toward financial security, experts often recommend setting aside the equivalent of three to six month's expenses that could be drawn on in case of a sudden need. To make sure that money will be available on short notice, emergency reserves should be held in a relatively liquid investment, such as an interest-bearing savings account or a money market fund. Also make sure that your emergency fund keeps up with increases in your expensesand account for the impact of inflation.
Pay Down Debt
Estimates from financial auditors showed the average American household owing just over $7,000 in credit card debt as of 2014. Reducing credit card balances and other consumer debt should be a priority for many households whose burden of debt restricts their ability to save and invest for the future. Reducing high-interest borrowing usually makes sense, even for those with smaller debt loads, in part because interest payments on credit cards, auto loans and unsecured consumer loans are not tax deductible.
But even on loans such as home mortgages, where interest payments are tax deductible and interest rates are relatively low, paying down debt can be a sensible move. Using a windfall to trim such a loan can increase the amount of money available for saving, or lower cash flow needs in retirement, for example.
Invest For the Future
If you are prepared for a financial surprise and have your debt under control, you can look more toward the future when you get an unexpected windfall. Take a close look at your goals to help you decide how to invest the extra money. Are you on track to reach some goals, but behind on others? Should you increase the amount you contribute to your employer-sponsored retirement plan or 529 college savings plan, for example?
Protect Against Risks
Adding to your insurance protection is another financial planning improvement to consider in the event a windfall comes your way. There are many forms of insurance that protect against the costs of accidents, illness, disability and death. However, there are no one-size-fits-all policies. Instead, the insurance decisions you make should be based on your family, age and economic situation. For example, there are two basic types of life insurance: term policies, which pay a death benefit for a specified period of time, and whole or universal policies, which have no term limit and accumulate value over time, but generally cost more than term policies.
In addition to maintaining adequate coverage for your home, autos and other assets, life insurance is a virtual necessity if you have a spouse and children, in order to cover their living and other expenses in the event of death. Life insurance may be less important if you don't have dependents to protect. (On the other hand, disability insurance, which provides an income stream if you are unable to work, is important for everyone.)
With the rising costs of healthcare, longer life spans, and uncertainty about the future of Social Security, you may also want to consider long-term care insurance, which helps pay for nursing home or at-home health care if the need should arise.
These are just some of the possible uses for a windfall. In the short run, however, keep in mind that you don't need to expect a refund to make use of the planning opportunities that tax season opens up. So, even if you're not anticipating a windfall from Uncle Sam or another tax collector, you may want to review your overall financial situation and planning priorities while many of the details are fresh in your mind from completing your tax chores.
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