You may or may not see it coming, but some day you may enjoy extra money in the form of a generous gift, an inheritance or a large tax refund. Whatever the source of your new funds, without a plan in place, you could end up spending the money as quickly as you received it. On the other hand, if you carefully explore how to best use your windfall, the money may continue to bear fruit for years to come. Consider the following options.
Eliminate Certain Debts
If you’re carrying high-interest credit card debt, consider using your windfall to shrink your balance. Chances are good that the amount you save in interest charges and fees will rival the return on most investments. Begin by paying down the balance on your card with the highest interest rate. As soon as that card is paid off, tackle the card with the next highest rate. Once you’ve paid off your credit card debt, it will be important to control your spending so your credit card debt doesn’t creep back up again.
You may also be tempted to apply your extra funds to your student loans or mortgage. But because student loans and mortgages often boast low interest rates – and the interest is often tax-deductible – you’ll often benefit by applying your windfall to investments or retirement savings instead.
Build Your Savings
Experts recommend maintaining an emergency fund of at least three to six months’ worth of living expenses. The average teacher's salary in California in 2012-13 school year was $69,234, so you may want to target an emergency fund of at least $16,000. That may seem like a lot, but if you haven’t built this financial cushion yet, consider using your windfall to do so. Otherwise, in the event that you lose your job or are faced with unexpected repair or medical expenses, you may have to turn to your high-interest-rate credit cards to cover the costs.
Invest for Retirement
Using your windfall to build your retirement savings can provide big benefits down the road. The longer your money is invested, the more money it can potentially earn through compounding (earning returns on top of returns). Consider using your windfall to fund a traditional or Roth IRA. A traditional IRA offers tax-deferred growth and potentially tax-deductible contributions, while a Roth IRA offers the potential for tax-free growth and distributions.* Or use your windfall to pay living expenses for a period so that you can boost contributions to your 403(b) or 457 plan* during that time.
* Withdrawals from a traditional IRA, a 403(b) or 457 plan will be taxed as ordinary income. Distributions from a Roth IRA may be tax-free if the account has been held five years or longer and the account holder is 59½ or older. Premature withdrawals from an IRA or 403(b) plan are subject to a 10% tax penalty. The 10% tax penalty does not apply to 457 plans.