If you recall, a few weeks ago I told you about my wife’s transition to being a stay at home mom. Well, a funny thing happened during the transition, we ended up with an influx of cash we had not expected and a significant reduction in costs. This surprise windfall was caused by 4 things:
- We had not accounted for my wife’s saved up vacation time. Her employee pays her for her remaining vacation time when she detaches from employment. I’m not sure what it says about how committed to work we are, but she left the working world with a month of employment.
- Added to that month my wife’s employer asked her to stay on for 2 extra months to close out some things and transition. In exchange they offered my wife her annual yearly bonus for which she would otherwise not qualify.
- Because we had assumed my wife was leaving work back in September we had cancelled daycare. This created some difficulty in child care for about 2 months where we relied on the good graces of being able to work at home, in laws, parents, and friends. The net impact was an additional 2 months of pay with no day care costs behind them. If you recall from my former post this means we banked upwards of 2K a month for those 2 months.
- Because of the extension, my wife was also eligible for the yearly employer profit sharing.
This left us with an interesting situation, what to do with a large amount of cash beyond what we normally deal with from month to month. I see this question a lot, what should I do with a surprise windfall? Money magazine posts it as what to do with $X K now. I’ve seen it discussed on the bogleheads.org forum as what to do with inheritance, lottery winnings, bond maturing, etc. In any case these questions is are at their root one question , what to do with money that is out of the ordinary and not necessarily expected?
Option 1: Spend the Surprise Windfall
Obviously, we could go on a spending spree. Yes, my wife earned it and we don’t necessarily need the money to get through the coming year on a single income. That being said, spend it on what? We have everything we value and don’t really feel we need to acquire any more to be happy. We travel as much as my vacation time allows. As spending it won’t really add value to our lives so we really shouldn’t spend it. I have no qualms about spending a portion of it had we truly had something missing from our lives, but the reality is there just is not anything we truly want at this time.
Option 2: Save It
Well, that leaves us with the old personal finance blogger standby, to save it. Now I could tell you to save it because it will save you X more years of works or Y (Y= Interest rate^ number of years till needed * dollars saved; X=Y/expense amount per year) more dollars down the pike. I could also tell you that it’s better to save to avoid Lifestyle inflation. Getting my family ready for a single income household is obviously easier if we start living that way before we have too. But you know what, I’m not going to tell you those things because chances are you’ve already heard them before. Besides as noted above I would have spent some of this money if I’d found the need.
How did I use my Surprise Windfall?
So what did I do with it? Well, we decided to split it between our mortgage and investments in equal proportions to our allocations. Since it was easier to put the new cash in the mortgage we adjusted my 401K and Roth IRA contributions to be all equity and used the cash payout as an excess mortgage contribution. Essentially after a few months it will be the same asset allocation as having split the cash between equities and bonds but it has been optimized for the sources of cash and the investments of each type with the lowest cost.
Allocations Should be Managed Across Accounts
Which brings us to an important point. As you pursue the road to retirement you will often end up with many types of investment accounts. 401K, after tax investments accounts, Roth IRA, Mortgage, and many others. When you choose your investment allocation you should always consider your allocation across your accounts rather then in a single account. So say you want to cover large caps, small caps, and mid caps for stocks. If your 401K has a low fee index large cap but a high fee small cap fund, then you should be buying almost all large cap in the 401k and use other accounts for small caps. The same with risk free investments, in my example above if my mortgage saves me 3% a year and my bond fund in my taxable account only earns me 2%, then rather then holding bonds in the taxable account proportionally to that accounts value I should pay my mortgage and drop the taxable bond fund allocation to 0 (within reason for liquidity obviously). Essentially I maintain my allocation but no single account reflects that allocation. I get the lowest expense cost for each holding as a result, and as you know low expenses have a massive impact on your returns over the long run.
Time Shifting Cash to Increase Tax Advantaged Contributions
One final option for those who do not max their 401k. When the one off payment occurs a more optimal way to invest it might be to increase your 401k deduction to equal your new found wealth and then use the wealth to live off during the same period. Thus you invest in the most tax advantaged method by time shifting the gain. Remember to look at all your investment options as a whole, not just a portion.
Have you ever had a surprise windfall? What did you do with it?