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How To Handle Sudden Wealth

Sudden wealth seems like the exact opposite of a problem. But for many, an abrupt change for the better in their financial lives can create a host of unexpected pitfalls.

Most people who successfully build wealth do so slowly and steadily through work, investment and planning. But windfalls large enough to change one’s financial life certainly aren’t unheard of. Arguably the most common way in which people’s financial statuses suddenly change is through a large inheritance or bequest, but that is only one scenario. You may also receive a large lifetime gift from a parent or grandparent. You may win a large divorce or other legal settlement. You may be a professional athlete or entertainer signing a large contract, or an early employee of a tech startup that goes public. Occasionally, someone even wins a huge lottery jackpot.

Depending on how you come by your newfound wealth, you may or may not have expected to receive it. If your parent makes you a large lifetime gift, for instance, ideally you have discussed the transaction in advance. On the other hand, if you are a young athlete who has just been drafted by a professional team for the first time, you are unlikely to have experience handling anything like the amount of money suddenly available to you. Regardless of background, anyone who receives a large windfall is at risk for what is often called “sudden wealth syndrome:” the stress and uncertainty that accompanies moving from one lifestyle to another.

If you have never managed a large sum of money before, it is much easier than you might think to squander your newfound wealth. Before you go on a spending spree or stuff the entire amount into your mattress, it’s crucial to pause and instead prepare a comprehensive plan to handle your new financial reality. Taking a calm and measured approach can help you to avoid common pitfalls and to make the most of your resources in the long run.

Traps To Avoid

HBO’s new football comedy “Ballers” focuses on Spenser Strasmore, a former NFL player turned financial adviser, and the pro athletes he advises. While the show incorporates all the heightened drama you would expect, the struggles with financial stability it depicts are all too real. A study published this spring found that about one in six former NFL players end up filing for bankruptcy within a dozen years of retirement.

And it isn’t only football players who run this risk. There is a long list of lottery winners who burned through large winnings in a few years, and 70 percent of affluent families lose their wealth by the second generation, according to the Williams Group wealth consultancy. So where does all the money go?

Conspicuous consumption is the default answer, and sometimes spending unwisely is indeed the culprit. But while it is easy to judge football players who buy huge mansions and young adults with outsize tastes for designer shoes and the latest Apple gadgets, the reality is that people suddenly handling much more money than they are used to can easily fall into the trap of believing their newfound wealth will never run out, no matter what they do.

For instance, buying a house with the proceeds of a large divorce settlement may seem like a reasonable choice. However, expenses such as property taxes and upkeep, not to mention plans to remodel or expand, can quickly tie up a great deal of your resources in a way that is very hard to undo if you later realize that you don’t have enough cash to meet your day-to-day expenses or that you are not on track to meet your retirement goals. And if you buy something that will depreciate quickly, such as an expensive car or a boat, your prospects of reclaiming much of the original capital through a sale are even worse. The best way to avoid such outcomes is to make a plan before you make large purchases, not after.

Family and friends may also have a hard time understanding that your new wealth has limits. Many of those who have lost their wealth did so in whole or in part because they provided funding for risky ventures or faltering businesses. Your loved ones may also fail to understand why you cannot just pay off their debt or buy them better homes, and it can be difficult to say no to such requests from people you care about. One possible solution is to designate your financial adviser as a “gatekeeper,” so he or she can be the one who actually says no. Your adviser should also vet all business and investment proposals, even those that come from people you personally trust. This is not to say you can’t provide any support to family and friends, but such support should be part of an overall plan to make sure that it doesn’t undermine your own long-term financial well-being.

Making A Plan

So if planning is the best way to avoid the pitfalls of sudden wealth, where should you begin?

First, you should assemble a team of professionals. One of these should be a fee-based Certified Financial Planner™ who is transparent about his or her compensation. This helps to ensure your adviser’s interests are aligned with yours. You may also want to consider a separate accountant or tax expert and a wealth manager, depending on what services and expertise your adviser offers. An estate planning attorney will also be helpful. Researching and vetting these professionals may take some time, but it is the first step in making sure your choices are shaped by those with sufficient experience to offer you the best advice possible.

Once you are satisfied with your advisers, the next step will be to determine whether your windfall has tax implications. While an inheritance or life insurance proceeds are not typically taxable, an exercise of stock options, the sale of appreciated stock and a lottery payout are all taxable events. Your accountant will be able to tell you whether you owe taxes, and if so, how much your total tax bill will be and when it will be due. Set aside any money you will need to cover state and federal tax liabilities before you start planning how you will spend and invest the remainder.

After setting aside the portion to cover taxes, a logical next step is to consider your debt. In most situations, it will make sense to pay off any outstanding “bad” debt right away. What makes debt bad? Generally, it is when you use debt to buy something that immediately decreases in value. The most common debt of this type is credit card debt, but if you have a line of credit at a particular store or an auto loan, those are also forms of debt it typically makes sense to pay off quickly.

“Good” debt is debt that creates value. For instance, educational loans, business loans and mortgages are all forms of debt that can produce long-term wealth and may offer tax breaks in some situations. Work with your financial adviser to get a more complete picture of what repayment schedule makes the most sense for these sorts of debts. For instance, you may do better to repay your student loans more slowly while investing more for retirement; in other situations, especially if your income phases you out of tax benefits such as interest deductions, paying off loans more quickly to reduce overall interest paid may make more sense.

Once you’ve set aside funds for your tax liabilities and assessed your debt, you should work with your adviser to develop a budget. This will serve as a road map that will allow you to preserve your new wealth and ensure you don’t outlive it - or even watch it grow, if that is your ultimate objective.

Just like any budget, your new plan should start with your income, including earnings, investment income, retirement benefits or any other income source you expect over time. It should also include your living expenses. The common adage, “don’t live beyond your means,” applies here: Use your budget to make sure annual living expenses don’t exceed annual income. If they do, you will need to reduce your expenses, increase your income or both until the income exceeds the output. Otherwise, you will need to dip into savings or sell investments to cover your shortfall. In certain situations, such as in retirement, this may be necessary; in these cases, you will still want to avoid invading principal too quickly, and thus risk exhausting your wealth during your lifetime.

Your new budget will necessarily make certain assumptions about inflation and the rate of return on your investments. Of course, no one can predict these with certainty, which means your budget will need some built-in flexibility. More importantly, your budget should be flexible because that makes it more likely you will actually stick to it over time. Set a budget too rigidly, and you run the risk of abandoning it altogether. A budget you ignore is useless, no matter how well it balances on paper.

A good budget will do more than simply ensure your income exceeds your living expenses. It should also allow for any large purchases you would like to make in the near term, such as a residence, a vehicle or a vacation. By including such big-ticket items in your budget, you can evaluate the implications before you actually make the purchase. This will allow you the confidence to move forward with an understanding of any adjustments or trade-offs the purchase may require.

Your budget will also help you with your next planning step: a long-term financial strategy. First, look to the future. Everyone’s financial goals will be different, and it is important to articulate what you specifically hope to accomplish in the years ahead. Some common concerns may be funding your own retirement, paying for a child’s education or future support, starting your own business or supporting charitable causes.

With the help of your financial planner and wealth manager, you can use these goals, your existing budget, and your tolerance for risk to develop a long-term investment strategy. While everyone’s particular financial plan and time horizon will be a bit different in the particular details, a well-diversified approach focused on the long term will be the best way to secure your financial goals. Your budget will be helpful in determining your target asset allocation (the mix of stocks, bonds and other investments in your portfolio), as well as the amount of risk you are comfortable assuming in pursuit of your objectives.

For example, if your budget in retirement will require you to draw down your investment portfolio, you may need to adopt an aggressive strategy - one heavily-weighted in stocks - to meet your goals in your later years. However, if such an aggressive allocation will be too much for you to bear, you may need to adjust your goals and the amount of money you plan to withdraw from your portfolio each year to settle on an allocation with which you will be comfortable.

Finally, your estate planning professionals will help you ensure that the wealth you worked hard to preserve and grow will pass to your intended beneficiaries upon your death. At a minimum, you should update your will - or create one, if necessary - to reflect your new situation. However, depending on how your wealth came to you and your long-term plans, you may want to consider more complex planning techniques, such as creating trusts or reconfiguring insurance arrangements. Competent professionals will be able to advise you on the best ways to go about making sure your wealth is protected beyond your lifetime if this is important to you.

Sudden and major shifts in your financial life can be a shock, and most people will need time to adjust to their new “normal.” But by taking the time to make a comprehensive and forward-looking plan, you can ensure that you make the very most of your windfall and take all the time you need to settle in and enjoy meeting your goals in the years to come.

Executive Vice President and Chief Operating Officer Shomari D. Hearn, based in our Fort Lauderdale, Florida headquarters, is among the authors of The High Achiever’s Guide To Wealth. He contribued to Chapter 12, “What Estate Planning Documents Do I Need?" and to Chapter 17, "Living And Working Abroad." He also contributed several chapters to the firm’s book for adults age 55 and older, Looking Ahead: Life, Family, Wealth and Business After 55.