06/22/2011 02:24 pm ET | Updated Aug 22, 2011

Use Financial Windfalls Wisely

If you're lucky enough to win a multimillion-dollar lottery, you don't need this column; you need a team of legal and financial experts to make sure you don't blow your chance for lifetime financial security. But if you receive a considerably smaller monetary windfall, whether a tax refund, divorce settlement, inheritance or work bonus, there are actions you can take to positively impact your current financial situation.

First, take a breath. Before you go on a spending spree, stash the money in a savings account until you've examined your total financial picture. Weigh existing debts, upcoming expenses and future needs (like retirement and college savings) to make sure you apply the money where it's needed most. A few options spring to mind:

Wake up and smell the tax windfall. Working Americans have larger paychecks this year due to a tax break that cuts their share of Social Security payroll taxes by close to one-third. However, a recent poll on the National Foundation for Credit Counseling (NFCC) website revealed that nearly half of the respondents were unaware of this windfall. "Some people will see an extra $2,000 in their paychecks this year, but regardless of the amount, put this money to good use while you have it, as the tax cut was only approved for 2011," said Gail Cunningham, spokesperson for the NFCC.

Save for emergencies. To protect your family against the impact of a layoff or other unexpected financial crisis (such as a medical emergency, car accident or theft), set aside enough cash to cover at least six months of living expenses. If you don't have an emergency fund, use at least a portion of the windfall to get one started.

Pay off debt. Before investing the money, paying off outstanding debt first might be better -- things like credit cards, car and student loans, and home equity loans/lines of credit. Start with debts having the highest interest rates first, then work your way down.

Keep in mind, though, that interest for certain types of loans, such as federally insured student loans, mortgages and home equity loans/lines of credit may be tax-deductible. IRS Publication 970 has details on student loans. IRS Publication 936 discusses home-related interest.

Save for retirement. Many people chronically underfund their retirement savings. One relatively painless strategy is to contribute a portion of your windfall into an IRA or your company's 401(k) plan. It's easy to have the money automatically withdrawn from your paycheck or bank account and the tax advantages these plans offer will make your savings grow even faster.

If retirement is still a ways off, a Roth IRA or 401(k), where your contributions are taxed now but withdrawals and their interest earnings are tax-free at retirement, may be your best bet. But keep in mind that, depending on the size of your windfall, it could possibly bump you into a higher tax bracket; in that case, a regular IRA or 401(k) might be wiser. Check with your financial advisor if you need help crunching the numbers.

Finance college
. If you've got kids, you're probably already worrying about paying for college. Although your own retirement security should come first (you can always borrow for education, but not for retirement), if you do get a windfall, consider opening a 529 Qualified State Tuition Plan or a Coverdell Education Savings Account -- two savings methods that offer terrific tax advantages.

To learn more about 529 Plans including tax implications, brokerage fees, investment risk and the potential impact on needs-based financial aid, read the guides at FinAid and the Securities and Exchange Commission. IRS Publication 970 discusses both 529 Plans and Coverdell Accounts.

Charitable contributions. Another good use for part of your windfall might a charitable donation. Besides making a difference in the lives of others, you can also deduct the contribution if you itemize deductions on your federal taxes, within IRS guidelines. For tips on selecting worthwhile charities, see my previous blog, Choose Your Charities Carefully.

Make a budget. Once you've used your windfall to pay off debt or start a savings plan, don't slip back into bad habits. Numerous free budgeting tools, including interactive budget calculators, are available online at sites such as the U.S. Financial Literacy and Education Commission's, the National Foundation for Credit Counseling, and Practical Money Skills for Life, a free personal financial management program run by my employer, Visa Inc.

Easy does it. Don't use a one-time financial windfall to create a new lifestyle you cannot sustain. For example, don't make a down payment on a new car if you won't be able to sustain increased monthly payments and higher insurance.

And finally, don't forget to reward yourself for having the discipline to use your financial windfall wisely. I like the 90/10 rule, where 90 percent goes for debt payoff or savings and 10 percent is to splurge on something fun.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

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