How to parcel out and protect an inheritance or pension payout in these uncertain times. By Kimberly Lankford, Contributing Editor December 4, 2008 Getting a big year-end bonus? You wish. Becoming a stock-option millionaire? So last century. But even in hard times, you could come into a chunk of cash that's independent of the economy and the stock market -- an inheritance, say, or a pension distribution. Or even that most dubious of windfalls: severance pay.Whatever the source of your extra money, you have a lot more at stake these days in figuring out what to do with it. You want to improve your financial situation -- and preserve your assets -- but which goal should you tackle first? How should you invest in this volatile stock market? Should you even invest at all? We offer both guidance and reassurance. Set Your Priorities Jason Hartman works for an employer that's still giving out bonuses. He is a technician who disposes of explosive ordnance for the U.S. Army -- in other words, he's on the bomb squad -- and he just received a $29,000 bonus for reenlisting. Hartman also has extra cash from the combat pay and tax-free income he earned while he was deployed to Iraq for four months in 2008. Advertisement Sergeant First Class Hartman initially contacted Kiplinger's while he was still in Iraq, looking for "a good place for the money until the economy straightens out." He and his wife, Tara, are both 29, and they have two sons, 4-year-old Logan and 2-year-old Reese. They'd like to use some of the money to pay down credit-card debt, boost their retirement kitty and save for a down payment on a house in Fayetteville, N.C. With so many goals, the Hartmans' first priority should be to do nothing. Brooke Salvini, a CPA and financial adviser in San Luis Obispo, Cal., recommends that you put an influx of cash into a savings account with an online bank, such as HSBC or ING Direct, so that you can earn interest while plotting your next move. And having the money on hand will be convenient if you owe more in taxes than has been withheld -- a common occurrence. Hartman is following through on the Army's equivalent of Salvini's advice by investing about one-third of his bonus in the military's savings-deposit program, which lets deployed service personnel contribute up to $10,000 to an account that earns 10% per year. Interest stops accruing 90 days after you leave the combat zone, and interest is taxable when the money is withdrawn. If you don't need your extra cash for everyday expenses -- as you might if you receive a pension payout or severance pay -- you could first use some of the money to pay down high-interest debt. The Hartmans are paying 7.9% interest on a $9,000 credit-card balance. Patrick Beagle, a former Marine helicopter pilot and now a financial planner who specializes in counseling military families, recommends that they pay off the entire balance because the savings on interest payments will make it easier to reach their other goals. Advertisement Financial advisers used to recommend that families maintain an emergency fund large enough to cover three to six months' worth of living expenses. But given the current state of the economy, many have bumped up that amount. Salvini suggests stashing enough for six to 12 months' worth of expenses, and double that if you or your spouse works in a field that's vulnerable to layoffs. And if you own rental property, you may need to set aside even more if you anticipate you'll have trouble collecting rent from cash-strapped tenants. In addition to your emergency fund, stow some money in a safe place, such as a one-year certificate of deposit, for expenses you anticipate in the near future. These might include home repairs, a renovation or a big trip. "Investing in the stock market is just for money that you won't need for at least three to five years," says Salvini. That's advice that investors are finally starting to appreciate. After the money in the Hartmans' military savings program stops earning interest, Beagle recommends that they put some of it toward a down payment on a house -- assuming they'll be able to stay put for at least five years (Hartman figures they'll be in Fayetteville for at least ten years). Beagle also recommends that the Hartmans hold their housing costs to no more than 30% of their take-home pay so that they won't struggle with monthly expenses after their extra cash is gone. While you're making all of these serious financial decisions, here's something that might not have occurred to you (or if it did, might have made you feel guilty): It's okay to have fun with some of your money. That's especially true if you've just been through a stressful experience -- such as being on the Army bomb squad in Iraq. Beagle says you could spend as much as 5% of any windfall -- $1,400 in the Hartmans' case -- on a weekend retreat, a family trip to a theme park or some other splurge. Advertisement That goes for money you inherit, too. "The person from whom you inherited the money would probably like to see you do something other than 'the right thing' with at least a small part of it, or even more," says Tim Maurer, a certified financial planner in Hunt Valley, Md. Retirement Versus College Notice that we haven't yet said a word about those two 800-pound gorillas, retirement and college. There's a reason for that, even if it sounds like heresy: People sometimes shovel too much into their retirement accounts. Then, faced with an emergency -- and no readily accessible cash -- they resort to piling up credit-card debt or paying a penalty to get early access to their retirement savings. Once you've set up a cash cushion, you can turn to your retirement nest egg. In the Hartmans' case, Beagle recommends that they earmark the remainder of Jason's bonus for retirement contributions. Because part of Jason's income for 2008 was tax-free combat pay, he's better off contributing to a Roth IRA before the federal Thrift Savings Plan, for which he's also eligible. Even though the TSP offers a tax deduction, it's not as beneficial given Jason's tax bracket. But if the Hartmans happen to have money left over, the TSP is a great deal. With expenses of less than one-tenth of 1%, "it's hard to beat," says Beagle. Advertisement If you have a 401(k) plan with an employer match, investing at least enough to capture the full match should be your priority. Then contribute to a Roth IRA, rather than a deductible IRA, if you qualify. If you have any self-employment income -- even if it's just from a freelance job on the side -- you can use some of your windfall to start a self-employed retirement plan, such as a Simplified Employee Pension (SEP) plan or a solo 401(k). That would lower your taxable income, and the money would grow tax-deferred until you retire. Once you've established your retirement savings, you can focus on college for the kids, perhaps earmarking 10% to 15% of your windfall for a state-sponsored 529 savings program. As a bonus, you're likely to qualify for a state income-tax deduction for your contribution, and you can use the money tax-free for qualified education expenses. Back in the Market Now that you have a blueprint for what to do with your money, the big question is when to get back into a volatile stock market. You could invest your lump sum all at once, and if you have a very long time horizon, "that's not necessarily a bad thing," says Karen Goodfriend, a CPA and financial adviser in Los Altos, Cal. But can you stomach wild swings of 400 to 500 points per day? "I find that a lot of people feel more comfortable regularly investing a little at a time," says Goodfriend. But with a chunk of cash, it doesn't make sense to shift a small amount from savings to investment accounts every month. One solution, says Dan Joss, a certified financial planner in Fairfax, Va., is to divvy up your investments into several larger pieces -- what Joss calls "diversifying by time." For example, you might invest one-third of your money immediately, one-third six months later, and the final third six months after that. Joss's reasoning: You won't know whether stock prices have bottomed until some time after the fact, so hedge your bets. If you get money through an inheritance, it may already be invested. But assets that were appropriate for the original owner might not be right for you. "Sometimes people feel an emotional connection to those investments," says Goodfriend, as in the case of shares of stock in a parent's former employer. In that situation, you could hold a small position in the original investment but invest the rest in assets that are more suited to your own time frame and risk tolerance. Managing a Pension Assets you inherit can be like found money; you may not need them right away, and you may have some discretion over how you use them. But money you receive as a lump-sum distribution from a pension plan or as severance pay is another story. Severance pay, for example, "is not money to be invested," says Salvini. "It's short-term money that needs to be safe." She recommends putting all of it into an online savings account and keeping it there until you find a new job. It's also important to "have a realistic spending plan for your severance pay so that it lasts through the job-hunting period." Receiving a lump-sum pension distribution is especially stressful right now. Salvini generally counsels her clients to take their pension in lifetime payments rather than as a lump sum, so that they know they have guaranteed income for life. That works best when you have other money in an IRA or 401(k) that you can use to cover additional expenses. If you do take the pension as a lump sum, however, put enough of it in a safe place to cover at least five years' worth of expenses. Any money over and above that can be invested more aggressively. After all, you may have to finance 20 to 30 years of retirement living, and you could outlive your income if you invest too conservatively. In fact, if the pension rollover represents the bulk of your assets, it could be worthwhile to seek professional advice. You get only one crack at the money, and you want to make the most of it.