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What to Do with a Windfall

A reader writes in to ask,

“Does it make sense to apply what I call the ‘retirement model’ to a large windfall — that is, spending a percentage of the windfall each year, while allowing the rest to grow? If so, what withdrawal rate do you recommend? The 4% rule, I gather, means that the money could likely run out after 30 years or so. Since I am 33 now, that means that it could run out just as I was hitting retirement. What withdrawal rate should I use to have the money last until I am 100?

And what about your readers? I’d be curious to see how other readers have dealt with this experience.”

Mike’s note: What follows is my answer to this question. If you’re comfortable sharing your own answer, please chime in via the comments section on this post.

You’re right that if you wanted the money to last for 60+ years, it would be wise to use a withdrawal rate lower than 4%.

To back up a step though, I doubt that’s the approach I’d apply at all. Rather than thinking about at what rate you can spend from this money, I’d simply incorporate the windfall into your existing plans. That is, now that you have this additional money, at what rate (if any) do you still need to be saving for retirement and other financial goals?

Matching Resources to Goals

To go about answering this question, I’d make a list of your financial goals in order of importance. For example:

  • Basic retirement living expenses,
  • A replacement for your aging car,
  • College for children,
  • “Fun” spending in retirement,
  • etc.

Then I’d make a list of resources available to meet those goals:

  • Your current and future work income,
  • Your existing savings (including the new windfall),
  • Social Security,
  • etc.

Then I’d play a matching game — allocating resources to satisfy your goals in order of importance. Once the highest priority goal is satisfied (using any combination of resources), you can start allocating resources to the next highest priority.

For example, if retirement is the #1 priority, are your existing savings (including the windfall) large enough that they would likely fund your retirement if you let them grow untouched between now and your planned retirement age? If so, then you no longer need to save for retirement every year, and you can begin allocating resources to other goals. (Of course, this decision should be revisited periodically based on how well the money is/isn’t growing over time.)

Tax-planning note: Even if you no longer have to save for retirement per se, it still likely makes sense to max out your retirement accounts every year. For example, contribute $16,500 to a 401(k) and $5,000 to a Roth IRA, while spending $21,500 out of the taxable windfall you received in order to effectively transfer as much of the windfall as possible to tax-advantaged accounts.

In short, my suggestion would be to make decisions from the broader perspective of how to meet as many of your goals as possible (in order of importance) using your total resources rather than trying to figure out what to do with just this one part of your resources.

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Comments

  1. I had this same question in my mind as I am trying to write my loved ones on how to life insurance proceeds if I pass away too soon. We’re talking between $500k and $1 million. I had two ideas:

    1.) Hire an investment advisor to invest the life insurance proceeds (assuming all would be a taxable investment account). This way he/she can take advantage of Fama-French 3-factor model for portfolio construction and maintenance, foreign tax credit, and tax loss harvesting. Order of preference: Portfolio Solutions, AssetBuilder, Index Fund Advisors, Merriman.
    2.) If my loved ones don’t want to use an advisor, throw all life insurance proceeds into Vanguard LifeStrategy Moderate Growth. Just set the maximum first year withdrawal to 4%, then adjust for 3% inflation.

    In either case, would it be wise to recommend working with a financial planner on a periodic basic to make sure the investment is appropriate for their needs? Places I’m thinking of including are from garrettplanningnetwork.com, napfa.org, and cfp.net.

    What are your thoughts on what is seemingly a broad strategy, even though it should really be person-specific? Does this seem suitable and appropriate for someone who has to deal with it in her/his mid-30s and wants insurance proceeds provide enough income to last 30 years (at least till age 60)?

    My idea is that:
    $1 million invested can generate about $40,000 in inflation-adjusted income for at least 30 years. (maybe $30,000 after tax)
    $500k invested can generate about $20,000 in inflation-adjusted income for at least 30 years (maybe $15,000 after tax)

    Of course, it is better to withdraw less but I’m just looking for a safe threshold based on initial investment of proceeds and portfolio mix of 60% stocks and 40% bonds.

    Your thoughts on all this would be appreciated!!!!

  2. RPS,

    First a question of my own: Why is the plan only for the money to last until age 60?

    Assuming there’s a good answer to that question, I think both plans sound reasonable — with, of course, the ever-present caveat that we don’t know how well future returns will support a 4% withdrawal rate.

    Personally though, I’d be inclined to think that if the portfolio ended up being closer to $1M — such that Ferri’s Portfolio Solutions would cost just 0.25% per year — the tax benefits (relative to the simple LifeStrategy fund method) might pay for the fee all on their own. In addition to tax-loss harvesting and the foreign tax credit, there’s likely some further gains to be derived from prudent asset location decisions (e.g., tax-sheltering bonds when possible) and potentially from using muni bonds in taxable space.

    Then any additional benefit received from the services would be pure gravy, so to speak.

  3. Thanks, Mike!!! The age 60 is for my wife in my case. When deciding on how much life insurance my family needs, I set age 60 as a minimum threshhold because prior to age 59.5, withdrawal from IRAs, 401ks, 403bs, etc. has a 10% penalty.

    Of course, lasting beyond age 60 is always better. My hope (in case I don’t reach age 60) is that my wife would be taken care of by insurance proceeds alone AT LEAST till age 60. In the meantime, money in retirement accounts would compound over time. Hopefully, she’ll be working and adding to retirement accounts over time as well. Once age 60 is reached, those assets would be accessible without penalty. Those assets would be the main source of income from age 60 onwards.

    All the above is just in case, though. If I pass away before 60 and my wife has enough income to meet her basic living expenses till she reaches age 60 through proper investment of life insurance proceeds, then we obtained the right amount of life insurance for its intended purpose. If it lasts beyond age 60, it’s a bonus.

    I think for life insurance to provide till age 120, I would probably need $4 million face value. Not worth it!! Life insurance is one of the many key components of our overall financial planning, not really “THE PLAN”. I just don’t want “too much” life insurance.

    After all, my real hope is that we’ll make it well beyond age 60. In our 50s and 60s, I hope we’ll have the ability to decide if and when we have accumulated enough assets to be financially independent. :;

  4. Thank you for the elaboration. Just as a reminder, distributions from an inherited IRA are not subject to the 10% penalty (though they are subject to regular income tax).

    Still, I think the overall reasoning makes sense. My concern had simply been to make sure there are assets allocated to providing for expenses after age 60 — and there are.

  5. I had a similar situation-I came into a good-sized inheritance last year. Luckily (or maybe it isn’t luck since we work diligently on maintaining our finances), my wife and I were already in a comfortable financial situation.
    The first thing we did was hire an estate attorney to settle my relative’s estate (as there were estate taxes due, etc). The next thing we did was interview several Certified Financial Planners and hire the one we felt comfortable working with.

    Our thought, which was on par with what our adviser recommended, was to incorporate the windfall into our current plans. This included paying down revolving debt, building a solid emergency fund, maximizing retirement savings, (in our case) prepaying some of our home mortgage, and then putting the rest to work in an appropriately diversified portfolio, which is still gradually being formulated, focusing on low costs, tax efficiency, and reasonable risk (which is obviously variable from person to person, though we made our risk tolerance clear to our Planner).

    We also worked to establish what we call “buckets”, meaning some of the assets are invested in very low-risk , easily accessible vehicles which will cover anything that may come up in the next 2 years (ie replacing fridge, unexpected home repairs, starting a family, etc). The next bucket represents funds that may be needed in the next 3-5 years (ie redoing driveway, maybe adding a deck, 2nd child, etc), with these assets invested approrpiately in something a little longer-term. The 5-7 year bucket, 7-10 year bucket, and 10+ year bucket are placed in progressively more stock-oriented, longer-term investments with the potential for greater growth. The amount you have will dictate how much is allocated to different time frames, but you get the picture.

    I do admit that right off the bat we did use a little bit of the windfall to “treat ourselves” to a nice vacation and dinner at a restaurant we would never otherwise go to – If anything, the passing of a loved one only reinforces the cliche that “You can’t take it with you”, so we did indulge a bit. Our overall view was that the assets we came into are not life-changing now, but if put to work sensibly, it could grow to a life-altering amount later in life (ie retire early, see the world, philanthropy, who knows)….Good luck

  6. Scott,

    Thank you for sharing your experience. Your approach sounds very prudent to me.

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