Investment Strategies for a Large Windfall or Inheritance
Receiving a large lump sum of money from an inheritance or other windfall can change your life -- especially if you make smart financial choices upfront about what to do with your newfound wealth.
Often, the best thing to do is to invest in assets that allow your wealth to grow over time, so that you can reap the benefits for years to come and perhaps even the rest of your life. However, deciding and researching the mechanics of how exactly to invest a large sum of money isn’t always straightforward. In fact, there are many factors to consider, particularly based on the type and size of your windfall.
Common types of windfalls
It often takes a long time for you to receive an inheritance if assets are transferred through the probate process. There are costs associated with this process as well, including payments to the executor of the estate as well as court fees.
Taxes may also reduce the value of an inheritance as well. The federal government charges tax on large estates, although up to $11.58 million can be transferred without taxes being assessed in 2020. These estate taxes and inheritance taxes are not charged when spouses transfer assets to each other and the exemption can pass between spouses so if one spouse leaves his or her entire estate to the other, the surviving spouse has two exemptions and can transfer up to $23.16 million with no federal tax implications. When taxes are charged, the estate pays them so this effectively reduces the value of money and property available to inherit.
Some states do charge estate taxes when smaller amounts of money are transferred. And a small minority of states charge inheritance taxes, the amount of which are determined based on the amount you receive and the nature of your relationship with the deceased. If you live in a place that charges these taxes, the value of your inheritance will be reduced.
Sale of company stock: IPO, acquisition, or merger
When a company is acquired, sold, or merges with another, this can produce a windfall both for the company founders as well as for anyone who has an equity stake. Depending on the terms of the deal, the windfall could come in the form of cash being paid for shares or could come in the form of stock or an option grant for the acquiring company.
Founders can potentially exclude up to $10 million from capital gains taxes if their stock shares meet the criteria for Qualified Small Business Stock (QSBS). The tax consequences for equity holders will depend whether they have exercised shares, vested options, or unvested options. The windfall may be taxed as long-term capital gains, short-term capital gains, or bonus money that ordinary income tax is due on.
Depending on the terms of the merger, acquisition, or sale of a company, there may be multiple cash payments made over time or employees may need to wait for options to vest before they can exercise them. There may also be limits on when stock shares can be sold.
Questions that financial and tax advisors can help you with, if this is the cause of your windfall:
- Do you want to have 95% of your net worth in a concentrated stock position that is likely also tied to your employment income?
- Do you need to reserve cash to exercise options in order to capitalize on the most strategic time to sell?
- What are the tax implications for selling now vs. later? Essentially, how many shares should you sell (if any) on what timeline?
- Tax Planning for When Your Startup is Acquired
- Cashing Out Startup Shares: Calculating Potential Value and Costs
- Startup IPO: Tax and Financial Planning
Major promotion or bonus
When you receive a major promotion that results in a large salary bump, this is generally the most straightforward type of windfall. You receive additional funds immediately in your next paycheck and taxes are withheld based on your tax rate and information you provided on your employer withholding tax forms.
If you receive a bonus at work, it is generally treated as supplemental income. This means taxes are withheld from your bonus at a flat rate of 22%. If the bonus is above $1 million, you are subject to withholding at a flat rate of 37% on funds in excess of $1 million.
You will still be taxed on your bonus at your ordinary tax rate when it comes time to pay your taxes, which means you could either have too much withheld from your bonus and get a larger refund after filing or have too little withheld and owe the IRS. Whether you owe or are entitled to a refund will depend upon your tax bracket.
Define your goals for the money: What’s your timeline?
Your investment timeline and goals will shape the choices you make regarding your investments.
If you need to access the money within a year or two, you’d want to choose safe investments with limited risk of loss as you don’t have time to wait out downturns in a volatile market. You’d also want to ensure you choose relatively liquid investments so you can access the funds when you need them.
If you have a very long investment horizon, you have time to weather ups and downs and should be more aggressive. You can also worry less about liquidity if you don’t need the money imminently.
If you’re hoping to maximize growth, you’ll make a different choice than if you want the investments to produce reliable income for the rest of your life. In the first case, putting the money into small cap stocks or emerging market funds might be the optimal choice while in the second you might prefer an annuity that guarantees lifetime income.
Build a diversified portfolio of assets
One of the best ways to limit risk while maximizing the chance at earning reasonable returns is to invest in a broad range of different investments. If you choose assets that give you exposure to different markets, industries, or sectors, there’s less chance of substantial loss. When some investments sustain losses, others will hopefully provide gains.
Understand the tax implications
Different investments are taxed in different ways. For example, the long-term capital gains tax rate is lower than the ordinary income tax rate for many investors. There are also tax-advantaged accounts subject to special tax rules. If you inherit an IRA, for example, you may need to make withdrawals on a certain schedule to avoid tax consequences that could reduce the value of your inherited funds.
Related article: Tax Planning for a Large Windfall or Inheritance
Consider getting expert advice
Choosing the right investments when you’ve received a large windfall can be complicated. As you can see, there are a huge number of considerations including risk tolerance, investment timeline, tax implications of your investments, and your current investment profile.
A financial advisor can provide insight into how to create a comprehensive long-term financial plan that maximizes your newfound funds and ensures you’re taking appropriate steps to make the money last as long as possible — perhaps even for your lifetime and beyond. Registered investment advisors and other financial professionals can also provide specific insight into choosing the right investments given your goals and size of your windfall. Some questions they will be able to help you with:
- Do you want to move assets to a trust?
- Do you want to move to a state with lower taxes? (Particularly relevant in 2020.)
- Do you want to keep working? For how long? What other household/family inputs do you need to consider?
- What is your risk tolerance?
An experienced advisor has worked with many clients over the course of decades to help manage windfalls similar to your own. They can both reduce stress associated with making the common mistakes associated with investing windfalls and help ensure you’re investing as wisely as possible so the wealth you’ve received can help you to build a stronger future.