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What to Do With a Windfall

From building an emergency fund to saving more for retirement, here are several smart ways to use your extra income.

By Kimberly Lankford, Contributing Editor, Kiplinger's Personal Finance

December 4, 2008

My wife reentered the workforce as a schoolteacher. Now we have an extra $40,000 after taxes to use toward our future. We're in our forties and have three young children (kindergarten and grades three and six). My income covers all of our household, vacation and family expenses. I currently contribute the maximum to a 401(k) plan with a 50% employer match. We're paying 5.875% on our mortgage and have 23 years left to pay it off, and we’re paying prime plus 1.01% on our home-equity line of credit. We have $40,000 in stocks, about $125,000 in our retirement accounts and $10,000 in a 529 college-savings plan. Lastly, we have no credit-card debt and no car loan or lease. What should we do with this extra $40,000?

You're already free from the first thing I recommend people do when they get a windfall: paying off high-interest credit-card debt. Paying off a credit card with an 18% rate is like getting an 18% guaranteed return -- a much better guarantee than you can find with any other investments. After that high-interest debt is gone, people have so much more money each month to devote to their other goals.

But you're already in great shape in that area. And you don't even have a car loan, which can also be good to pay off with a windfall, especially if the interest rate is higher than the return you could get from investing the money.

But it does look like one thing is missing from your portfolio: an emergency fund. You should keep at least three to six months' worth of living expenses in a liquid, guaranteed account. Having that emergency cash is especially important in this economy, when layoffs are common, banks are pulling back on home-equity lines of credit and investment accounts are down. You don’t want to have to sell stocks at a loss, land in debt or have to pay a penalty to access retirement funds if you end up with unexpected expenses.

Brooke Salvini, a CPA and financial adviser in San Louis Obispo, Cal., recommends bumping up emergency funds to cover six to 12 months' worth of expenses, and double that if you or your spouse works in a field that's susceptible to layoffs. She recommends keeping the money in a savings account with an online bank, such as HSBC or ING Direct, so the money is accessible but still earning some interest.

After that, you can add more to your retirement savings. If your wife has access to a 403(b) at her job, which most teachers do, then invest some of the extra money in that account. And, if you qualify, invest in a Roth IRA, which will grow tax-free for retirement. You can each contribute up to $5,000 to a Roth if your joint income falls below $159,000 in 2008. The contribution limit gradually phases out until your income reaches $169,000. (The income limit is $116,000 for single filers.) People age 50 and older can contribute $6,000. You have until April 15, 2009, to contribute to a 2008 Roth IRA. See Why You Need a Roth IRA for more information.

Because your extra money is coming with each paycheck, rather than in a lump sum, consider signing up for an automatic investing plan and having a fixed amount transferred to the Roth every month from your paycheck or bank account. This strategy also lets you make the most of dollar-cost averaging. By investing a fixed amount over time, you buy more shares when prices are low and fewer when they’re high, which tends to lower your average share price and makes investing in a volatile market much less stressful. See Hold Fast to These Five Tenets for more information.

And if you still have some money left over, boost your 529 contributions, which will provide tax-free money for college costs, and you may get a state income-tax deduction for your contributions. See Open a Low-Risk College Fund for advice about saving for college in this volatile market.

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