Imagine this situation – you’ve just had a lot of money come into your life unexpectedly – maybe it was an inheritance, or a big bonus from work, or maybe you won the lottery! You feel like you’re invincible – completely on top of the world and rich.
But the question is now, what to do with a money windfall… and every situation is completely different, but below is a guideline of how I would handle it if I was lucky enough to get a big bonus check!
Option #1: 401k
This is the most important thing. I think it is a 100% MUST to contribute to your 401K to at least max out the company match. I know many people that won’t do it and it’s literally throwing money away.
If you make $1000/week, or a salary of $52,000, and say your match is 4% for every 5% you put in (pretty common to see a 100% match for the first 3%, then a 50% match for 4-5%) then you get $80 for every $100 that you put in.
And if you really think about it, it’s not even $100 that you’re actually “sacrificing” from your paycheck because it is likely pre-tax (unless you select the Roth option), it’s more like $75 – $80.
So, essentially a 1:1 match.
I used to have a teacher in sixth grade that would always say “DBD” which stood for Don’t Be Dumb. So please, I’m begging you, please max out your company match if you have one. DBD.
[Editor’s Note: Wondering what a Roth is? Here’s a simple explanation on the differences between a Roth and Traditional 401k.]
Option #2: Emergency Fund
Admittedly, this is the one that I struggle with the most. It is very hard for me to convince myself that just sitting on cash is a good thing and should be of very high importance. But I’m trying to make it a priority.
I’ve heard people say things like you need to have six months of salary saved up so if you lost your job you could continue to maintain the same lifestyle. I think that is absolutely ridiculous.
I’m not sure about you, but if I lost my job, I would start doing something before I got to the six month point of no income at all, and I would definitely cut back my expenses and not live the same lifestyle.
I think 2-3 months of expenses is a good spot to have saved up. And the bigger your family, and the more that other people are depending on you, the more important it is to grow this number.
Also, with the help of companies like Ally, now you can let this emergency fund sit and earn 2.2% interest. Again, not a crazy number, but that’s over $200/year if you have $10,000 sitting in that account.
It makes it a little bit easier to convince myself that an emergency fund isn’t completely wasting money. Yes, that money might seem under utilized and worthless……until you need it.
Option #3: Payoff Bad Debt
Not all debt is bad debt necessarily. For instance, a 3.5% interest rate on your mortgage is not bad debt. And neither is a 3% student loan. But that credit card that has 24% interest rate on it… yeah… pay that thing off ASAP.
My typical rule of thumb is that any loan with 6% interest or higher I will pay off before investing. I assume that the stock market can get 6% for me, which is very conservative, but the feeling of paying off loans is great – and that return is guaranteed (unlike the market). This break-even point will be different for everyone, but 6% is my comfort level.
When you’re paying off this debt, ALWAYS target the highest interest rate first. I know this might sound obvious, but it’s not.
Some people use the “Snowball method” where you pay off the lowest balance first so that you build up mental momentum and get addicted to paying off loans, but that’s not for me.
If you have to do that, then fine. But you will pay more in interest. That’s a guarantee.
But, as I always say about diets and working out – the best diet/workout for you is the one that you will actually do. This also applies to getting yourself in a good financial situation.
Option #4: Take advantage of all potential tax advantages
I know I already mentioned a 401K which does have tax advantages, but this section is more so in regard to putting some of it in an IRA or a 529 if you’re currently doing either one of those.
If you’re not, I highly recommend that you start.
I currently invest in a Roth IRA and a 529 so those are always very high up on my priority list because the earlier I can put that money into those accounts, the more compound interest becomes a role in building that snowball even faster.
[Editor’s Note: A 529 is a college savings account for your child, and the money put into it can be invested in multiple ways. Here’s a quick guide by Fidelity about 529 plans]
Option #5: Pay off “good” debt
Pay off loans that might not be high interest rate, but maybe you just want to get rid of them and free up some extra income. Paying off debt is never a bad thing. It might not be the most opportunistic way to use the money, but it’s never bad.
Option #6: Treat yourself!
This is last, but it is very important to do so, especially if your money windfall is from a performance-based goal, such as a bonus at work. You should reward yourself a little bit and get something that you’ve been wanting.
After all, life is about living.
If you never let yourself live in the moment, then really what is the point of doing all this and busting your butt at work? Your work rewarded you. Take care of your family and future self but also let yourself be rewarded as well.
Money Windfall Example: $15k Bonus
So now that you can see a general guideline, I’m going to throw a hypothetical situation at you. Imagine you just got a $15,000 bonus at work and you can’t figure out how to put that money to use. Let’s also make the following assumptions:
- Current Emergency Fund is $6000 (1.5 months of expenses)
- Car Loan of $10,000 at 6% interest
- Credit Card debt of $8000 at 24% interest
- Company offers 4% 401K match on 5% employee contribution
- Student Loans of $10,000 at 3.5% Interest
- You have both a Roth IRA and a 529 (current values are not important; just know that they’re not where they need to be)
What do you do? Where does your money go? Well, if it was me, this is what I would do:
- Max out company 401K match by putting in 5% – $750
- Grow Emergency Fund to 2 months expenses – $2000
- Pay off Credit Card – $8000
Loan* – $1250
- For me, 6% is my breaking point of whether to invest or pay off a loan, so I am going to “hedge my bets” and find a middle ground of paying this debt/investing
- Contribute to Roth IRA – $1600
- Contribute to 529 – $1000
Loans – $0
- My loan is 3.5% vs. my assumed return of 6% in the market, so I am not going to pay down this loan more than my minimum payments require me to.
Myself! Buy a new golf driver for $400
- This might seem like a waste to you, and if so, that’s fine. I understand this isn’t the “optimal” way to grow my net worth, but if spending less than 3% of my bonus on something for immediate use is what it takes to motivate me for the next year, then so be it – to me, that’s an investment in the next year’s bonus.
I asked a friend this exact question and their response was the following:
- Max out company 401K match – $750
- Grow Emergency Fund to 3 months expenses – $6000
- Pay off Credit Card – $8000
- Car Loan – $0
- Contribute to Roth IRA – $0
- Contribute to 529 – $0
- Student Loans – $0
- Treat themselves – $250
So, who is right and who is wrong? The answer is neither. Neither person was right or wrong.
To me, I don’t think that much of an Emergency Fund is needed, but my friend has two children and they want that extra security for their family.
It really just depends on your comfort level for risk and what you want in your life.
If you don’t want kids or to go back to college, then a 529 is not necessary. If you are closer to retirement, then maybe you want to max that Roth IRA out sooner rather than later.