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What can you do with unexpected income?
You’ve just received a windfall! Here are the best strategies to handle unexpected income.
Unexpected income can take many forms, from a lucky scratch ticket to an unexpected inheritance. Before you head out the door for that new state-of-the-art television, here are some strategies to maximize the benefit of windfalls.
Richard Thaler, a Nobel prize-winning professor of financial behavioural science and economics at the University of Chicago Booth School of Business, created the theory of “mental accounting” which looks at how people spend and how they categorize money. People are far more likely to overspend with unexpected money because they don’t count the funds into their normal income and expenses; it’s play money, and therefore easier to spend. For example, someone who receives an increase in pay of $200 may not spend it on a new electronic device, but might buy the device if they won the same amount of money. When people consider windfalls as part of income, they are less likely to make impulse purchases.
Beat the mental accounting trap by putting the money to work for you while you decide where you can get the best bang for those bucks given your financial situation. It’s much easier to spend money in your wallet or in your debit-friendly chequing account. Instead, put the sum into a Tax-free Savings Account (TFSA), a 30-day term Guaranteed Investment Certificate (GIC) or a Money Market fund, where it will be harder to get at. Before you invest the funds in your Registered Retirement Savings Plan (RRSP) to receive the tax receipt, remember that RRSP withdrawals are taxed as income at your marginal tax rate and that income tax is withheld at the time of the withdrawal, (10–30% depending on the amount of the withdrawal).
Ask an expert
Speaking with a financial advisor can help you prioritize and put the money where it can provide the most benefit for your financial situation. If you have a group retirement plan with your employer, you can contact the service provider to obtain advice from a financial expert. You can also consult with friends and family.Consider your financial situation
What stage of life are you in? If you are saving to buy your first home, putting the windfall towards your down payment may make sense. Do you have high-interest credit card debt? Paying off the cards with the highest interest rates helps both your credit rating and your financial situation. If you have young children or grandchildren, you could start a Registered Education Savings Plan (RESP) to help fund the cost of post-secondary education. Are you paying off student loans or do you have a mortgage? Making a lump sum payment goes straight to the outstanding principal. Monthly payments are applied to accrued interest first.
If you are nearing retirement age, it may not make sense to deposit all the funds into an RRSP. You must evaluate if the taxes you save with the contribution to your RRSP are greater than the taxes you will have to pay when you withdraw from your RRSP in retirement. Buying an annuity with that extra money can be a good option for you if you are worried about outliving your savings or if you want to secure yourself a guaranteed income for retirement. You could also decide to max out your TFSA’s unused contribution room. At retirement, the amounts you withdraw from your TFSA won’t be taxed and won’t affect the calculation of income-tested benefits such as your Old Age Security and drug benefits.
If you had a major house or car repair, or a sudden illness, how would you pay for it? Setting aside some of the money for an emergency and putting it in a TFSA ensures unexpected costs won’t send you into a tailspin. Your funds will grow tax-free while they remain in the TFSA and there are no tax implications when you withdraw the funds later.
Yes, you read that right. While it’s a bad idea to blow the wad, keeping some play money makes you more willing to be fiscally responsible with the balance. Don’t go crazy, though, a good rule of thumb is 5–10%.