If you’re lucky enough to find yourself in possession of a bundle of cash that isn’t immediately needed to pay bills, you have some thinking to do. How to use that money? Whether it came your way via an on-the-job bonus, an inheritance, or an unexpected refund, you have the opportunity to put it to work for you in a variety of ways.
Instead of going on a shopping spree, you could deploy the funds to improve your financial situation and build wealth. Options include paying down debt, contributing to retirement goals, and beyond. Read on to learn the full story.
The Opportunity of Extra Money
At some point, you may find some extra money heading your way. Perhaps you get a bonus for wrangling a complicated project at work. Or you didn’t realize that you’d overpaid your taxes one year. Or maybe an inheritance comes your way.
When funds turn up that you weren’t expecting, it may be tempting to buy a bunch of cool items you’ve been admiring or to take friends and family out to a lavish meal or away for a weekend. But then, once that cash is gone, there’s no getting it back.
Instead, you might look at the money as a means to enrich your financial standing. (Or use most of it that way, and go shopping with a small amount of it.)
A windfall can be a once-in-a-blue-moon opportunity to pay off debt or plump up your emergency fund. It can help you boost your retirement savings or kick your savings for a future goal into high gear.
Yes, it takes discipline to put that money to work vs. splashing out with it at your favorite store. But doing so can have a long-term positive impact on your finances.
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1. Build a Solid Emergency Fund
If your emergency fund is low (or nonexistent), you might use your new windfall to build it up.
Having an emergency fund gives you a financial cushion, along with the sense of security that comes with knowing you can handle a financial set-back (such as a job loss, medical expenses, or costly car or home repair) without hardship.
Having this buffer can also help you avoid having to rely on credit cards for an unexpected expense and then falling into a negative spiral of high interest debt.
How Much to Save in an Emergency Fund
A general rule of thumb is to keep three to six months’ of monthly expenses in cash as an emergency fund. Two-income households may be able to protect themselves with three months’ worth of savings. If you’re single, however, you may want to aim closer to having six months’ worth of living expenses saved up.
Consider keeping your emergency fund in a separate high-yield savings account, such as a money market account, online saving account, or a checking and savings account. These options typically offer higher interest rates than a standard savings account, yet allow you to access the money when you need it.
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2. Tackle High-Interest Debt
While mortgage loans and car loans tend to offer lower interest rates since they’re secured by collateral, the same can’t be said of unsecured debts, such as credit card balances, student loans, and personal loans. Credit card debt can be especially hard to pay off, given that the current average interest rate is over 20%.
If you carry any credit card or other high-interest debt, you might want to use your windfall to jumpstart a strategic debt payoff plan, such as the debt avalanche or debt snowball method, in order to pay it off as quickly as possible.
Strategies for Paying Down Debt
The avalanche method involves ranking your debts by interest rate. You then put any extra money you have towards paying off the debt with the highest interest rate (while continuing to pay the minimum on other debts). After the balance with the highest interest rate has been completely paid off, you move on to the next highest interest-rate balance (again, putting as much money as you can toward it), and then move down the list until your debt is repaid.
With the snowball method, you focus on paying off your smallest debt first (while paying the minimum on your other debts). Once that balance is paid off, you take the funds you had previously allocated to your smallest debt and put them toward the next-smallest balance. This cycle repeats until all of your debt is repaid.
Using your extra cash to pay off debt has added benefits. You may build your credit score as your credit utilization ratio (the amount of available credit you’ve used vs. your credit limit) goes down.
In addition, once you clear your debt, you won’t have to budget for debt payments anymore, which is essentially getting extra cash all over again.
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3. Invest in Retirement Accounts
Here’s another idea for what to do with extra money. You might use it to grow your retirement accounts. There are a couple of options to consider here.
401(k) and Employer Match
Does your employer offer a 401(k) with matching contributions? If so, this can be a powerful tool to help you save for retirement.
Not only does a 401(k) help lower your taxes (since this money comes out of your salary before taxes are deducted), your employer’s matching contributions are essentially free money and can provide a nice boost to your retirement savings.
If you’re not currently taking full advantage of matching funds, you may want to adjust your contributions to help ensure you’re making the most of this benefit. And if a windfall comes your way, you may want to deposit it right into your account.
Start or Fund an IRA
What do you do if you don’t have a company plan or you’ve hit your contribution limit there? You might consider using your new influx of cash to open up (or add to) an individual retirement account (IRA).
While retirement may feel a long way off, starting early can be a smart idea, thanks to the magic of compound earnings (that’s when the money you invest earns interest/dividends, those earnings then get reinvested and also grow).
There is also a possible immediate financial benefit to investing in an IRA: Just as with a 401(k), your IRA contributions can possibly reduce your taxable income, which means that any money you put in this year can lower your tax bill for this year.
You’ll want to keep in mind, however, that the federal government places limitations on how much you can contribute each year to retirement funds.
Recommended: IRA vs. 401(k): What’s the Difference?
4. Explore Additional Investment Options Money
A little windfall can offer a nice opportunity to buy investments that can possibly help you create additional wealth over time.
Stock Market Investments
For long-term financial goals (outside of retirement), you might consider opening up a brokerage account. This is an investment account that allows you to buy and sell investments like stocks, bonds, and funds like mutual funds and exchange-traded funds (ETFs).
A taxable brokerage account does not offer the same tax incentives as a 401(k) or an IRA but is much more flexible in terms of when the money can be accessed.
Though all investments come with some risk, generally the longer you keep your money invested, the better your odds of overcoming any down markets. Your investment gains can also grow exponentially over time as your earnings are compounded. Worth noting: Past performance doesn’t guarantee future return, and while your money may be insured against broker-dealer insolvency, it is not insured against loss.
While investing can seem intimidating, a financial planner can be a helpful resource to help you create an investment strategy that takes into consideration your goals and risk tolerance.
Real Estate Investments
Another option might be to look into real estate investments. One possibility: REIT investing, which stands for Real Estate Investment Trust. This is a kind of company that operates or owns income-generating properties.
You can buy shares of REITs as a way of investing in different aspects of the real estate market, and you can do so for small amounts vs. buying an actual property. In this way, REITs can make it possible for people to affordably invest in real estate projects, including those involving large-scale construction.
5. Save for Future Goals
Still wondering what to do with extra money? If you already have a solid emergency fund and your retirement account is growing nicely, you may want to think about what large purchases you are hoping to make in the next few years. That could be buying a new car, accruing a down payment for a home, doing a renovation project, or going on a family vacation.
A lump sum of cash can be a great way to jumpstart saving for your goal or, if you’re already saving, to quickly beef up this fund.
Short-Term vs. Long-Term Goals
When thinking about goals, it can be helpful to divide them into short-term goals and long-term ones. Typically, short-term goals are ones you want to achieve within a year, while long-term ones are those that have a longer runway to save.
So a short-term goal might be saving for a vacation next year, and a long-term one could be accumulating enough money for a down payment on a property.
Creating a Savings Plan
For things you want to buy or do in the next few months or years, consider setting up multiple bank accounts so you have a separate savings account that is safe, earns competitive interest, and will allow you to access the money when you’ve reached your goal.
Some good options include a high-yield savings account at a bank, an online savings account, a checking and savings account, or a certificate of deposit (CD).
Keep in mind, though, that with a CD, you typically need to leave the money untouched for a certain period of time or else pay a penalty.
The options directly above may also be a good place to put your extra money as you save up for a longer-term goal. But you might also look into whether there are suitable investments (see #4 on this list) that involve a bit more risk but offer potentially higher reward.
The Takeaway
Wondering what to do with a lump sum of extra money is a good problem to have.
Some options you might want to consider include: setting up an emergency fund, paying down high-interest debt, starting a savings account earmarked for a large purchase, or putting the money into your retirement fund or another type of long-term investment.
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