5 Smart Ways to Use an Unexpected Cash Windfall

Sometimes, in this crazy world, something wonderful happens. You fall in love. Your cat curls up on your chest and falls asleep purring. Or, perhaps most magical of all, you get a great big chunk of cash on top of your normal earnings.

This recently happened to my cousin—she received a lump sum as a retention bonus at work. You may get an annual bonus, or win a few thousand bucks on a scratch card, or find a box full of non-sequential, unmarked hundreds buried in your back garden (it’s probably fine??). However it happens, a windfall is a wonderful thing.

Unfortunately, a lot of people squander their good fortune. A colleague of mine, for example, won some unexpected money playing craps in Atlantic City and used the money for a big night out and an Apple Watch. There’s nothing inherently wrong with that, I guess, but there are definitely smarter ways to use bonus money when it comes along. Today, we’ll take a look at why we tend to waste our windfalls and run through a list of smarter uses for life’s unexpected bonuses.

money jars mental accounting flannel pizza

Why do we waste our financial windfalls?

Humans are complex and irrational beings, riddled with mental quirks called cognitive biases. Cognitive biases are, basically, the systematic ways that we all depart from perfect rationality. Cognitive biases were first identified by psychologists, then behavioral economists picked them up and ran with it. Today, behavioral economists use cognitive bias theory to explain why people do not actually act like the perfectly rational beings traditional economic theory expects us to be.

One cognitive bias we all have is called mental accounting. Basically, the idea here is that we don’t treat all money the same way. We tend to put our money into mental buckets and treat it differently based on where we got it or what we plan to do with it.

For example, there are plenty of perfectly lovely people walking around this world that have a special savings account with $8,000 in it for their wedding, and $12,000 in credit card debt at a 24% APR. This is crazy. That credit card debt is going to cost a fortune if it isn’t paid off fast—in a year it would cost more than a quarter of those wedding savings in interest. The rational thing to do would be to use that $8,000 to pay off the credit card immediately. But people aren’t rational. In our minds, the money in the wedding savings account is “special” and shouldn’t be used for something mundane like paying down a credit card, even if that’s the ace move.

You see this a lot with tax returns. If we were rational, we would treat tax returns the way we treat our salaries, and use that money to pay down debt, add to our savings, and cover our expenses. But instead, we treat tax return money as if it’s special and use it to buy things we would otherwise never consider purchasing.

And that’s why we waste our windfalls. We treat windfall money as “special” money, and we don’t apply our normal financial rules to it. Understanding our tendency to do this is the first step to changing our behavior. For step two, let’s take a look at some smarter ways to spend that windfall.

1. Pay down debt

This is probably the best use of your windfall for 7/10 people. If you are carrying high-interest credit card, student loan, mortgage, or auto loan debt, using your windfall to make a dent in that balance is the smart thing to do. It will save you money, and get you close to living debt free. It may feel sad and depressing to put your windfall towards your stupid credit card, but it truly is the right choice. Pick the debt with the highest interest, bite the bullet, and do it.

2. Finance your emergency savings account

Let’s say your debt situation is handled. Maybe you just don’t have any debt, or you have only zero-interest debt or something like that. The next step, if you don’t already have a fully funded emergency savings account with about 3-6 months’ worth of expenses in it, is to use your windfall for emergency savings. This is an investment in risk management and peace of mind. Every woman needs an emergency savings account, so make yours a priority.

3. Max out your retirement contributions

OK, so say you’re basically amazing, have no debt, and already have a juicy emergency savings account. The next smart but sadly unglamorous move is dropping your windfall into your retirement savings account.

As long as you don’t put more than $18,000 into your 401(k) or $5,500 into your IRA a year, putting your windfall into your retirement savings account is a great option. It will reduce your tax bill—which is important given that you’re likely to be taxed on your windfall—and it will help set you up for a comfortable retirement.

If you’re young, throwing a lump sum into your retirement account now is super, extra smart, because you’ll have 30 or 40 years to grow that money. If you put a $2,000 windfall into a retirement account that earns a conservative 5% a year for 35 years, that $2K will be magically transformed into $11,000 without you doing one single extra thing. Nice.

4. Save for an upcoming expense

This is kind of a special case of #3. Let’s say you have little debt and a comfortable emergency savings account. Saving for retirement would be great, but perhaps you are already hitting the tax-free threshold, or you are facing a big upcoming expense—buying a house, having surgery, or something similar. In that case, it may make sense for you to direct your windfall to a medium-term savings account instead of to your retirement funding. Depending on your time horizon, you may want to consider using the same type of higher-yielding, easy-access account as you use for your emergency savings, or something with a longer lead time and a higher yield, like a certificate of deposit (CD).

If you know, for example, that you want to buy a house in three years, putting your windfall into a high-yield, three-year CD is a great idea—it will help you finance your down payment when the time comes.

woman texting phone sitting

5. Start investing

Now, this is something that people may find a little intimidating, but hear me out.

Retirement savings are wonderful and important, but they have limits. Only the first $18,000 you dedicate to your 401(k) is tax-free, and the money you put in is basically trapped until you hit age 59.5 (you can withdraw it earlier, but in most cases, you’ll pay a steep tax penalty).

Emergency savings are similarly wonderful and important, but they also have limits, primarily that the interest you earn on your savings account is likely to be very low. In fact, it’s likely to be less than the inflation rate, which means that the money you have in that account actually loses value over time.

So, you may want a flexible saving option that delivers decent growth. In the historical long term, nothing has created wealth quite like the U.S. stock market. Most Americans are exposed to the stock market only through their retirement accounts. But non-retirement stock market investment accounts can be a very powerful way to build wealth and add to your savings. And today, they are actually really accessible thanks to so-called robo advisors. Robo advisors are basically technology platforms that allow you to invest easily and cheaply in low-cost index funds.

You can open an investment account with Betterment with just $1 (although that would be dumb and you should use more than a dollar) or with Wealthfront with just $500. It takes you only a few minutes and is so simple that I could do it.

Both Betterment and Wealthfront will ask you a bunch of questions when you sign up, and then they will recommend a portfolio allocation. Basically, a portfolio allocation is how much of your investment you put into different asset classes—in this case, stocks or bonds.

What makes these platforms extra magical, besides their low minimum investments, is that they charge very low fees. Depending on how much you use to fund your account, you can pay as little as 0.25% a year, which by historical standards for stock market investments is NOTHING. I personally have used Betterment for my non-retirement investing for a couple of years, and have found it easy to use, transparent, and effective.

And now for the big, ol’ but. Investing in the stock market is risky. Your money can grow, but it can also shrink. You’ve heard of the Great Depression, right? Well, during that period, the stock market lost over 50%. For every $100 people had invested, they ended up with $50. Not pretty. On the flip side, people who invested in the stock market at the end of the Great Recession in 2009 made a return of over 200%. Ups and downs.

If you have the misfortune to invest at the top of the market, you can lose both your metaphorical and actual shirt. Right now, the stock market has been growing steadily for over eight years. That may possibly mean that we are due for what they call a “correction” – which translates as a big fat fall in the market.

Tragically, it is basically impossible to predict when the market will rise and when it will fall. Therefore, many financial professionals recommend something called dollar cost averaging. This is what I personally do. Dollar cost average just means that instead of putting a big chunk of money into the market at once, you put in a fixed dollar amount on a regular schedule. Sometimes the market will go up, and you’ll be buying fewer shares, and sometimes it will go down, and you’ll be buying more. In the long-term, statistically, you should do OK. The alternative is to put in all your money at once and take the chance that you have bought at the top and the market is about to fall.

Bottom line: If you’re thinking about investing your windfall, you should, of course, do you. But here is what I do with my windfalls: I put part of the windfall into my 401(k), and then I put the rest into a decently high-yielding savings account that is linked to my Betterment account. Every month, I have an auto deposit set up that takes a fixed amount of money from that savings account and puts it into two different Betterment accounts—an aggressive one with lots of stocks, and a defensive one with fewer stocks and more bonds. If you want to start investing beyond your retirement savings, there are worse ways to do it.