Before making decisions about a cash windfall, you must identify its purpose.
Laura answers a listener’s question about the best way to manage a windfall. You’ll learn 6 steps to follow based on your financial situation, age, and risk tolerance.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Teresa P. says, "I just listened to your recent podcast on UGMA and UTMA accounts. I'm 38 years old and discovered about three years ago that my mom set up one of these accounts for me, and I had to pay taxes on it. Should I keep the money where it is or transfer it to a different account, such as a Roth IRA, brokerage, or high-yield savings?"
Thanks for your question, Teresa! You must have been pretty surprised to find that you own assets in a custodial account. Knowing what to do with an unexpected windfall can be confusing, but it's a terrific problem.
This show will review smart steps for managing a windfall based on your financial situation, age, and risk tolerance. These tips apply even if you don't have extra cash, so stay with me!
Hey, friends, and welcome back to the Money Girl podcast—I appreciate you downloading the show! I'm Laura Adams, an award-winning author who's been bringing you personal finance tips every week since 2008, with over 40 million downloads.
I'm also a keynote speaker and work with select brands doing on-camera and writing work as a spokesperson and consumer advocate. If you're interested in collaborating for a speaking event or PR campaign, please reach out!
As always, you can reach me using my contact page at LauraDAdams.com. That's also where you can learn more about my work, award-winning personal finance books, and money courses. You can also leave me a message by calling 302-364-0308.
6 smart steps for managing a cash windfall
If you didn't listen to last week's show about UGMA and UTMA custodial accounts, they're short for Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA). Both accounts allow an adult to transfer various assets to a minor but permit different assets.
The adult gift-giver or custodian controls UGMA or UTMA assets on behalf of the beneficiary child until they reach the age of majority, which varies by state but is typically 18 or 21. And once the minor becomes an adult, they legally own the account assets and can use them as they wish.
Gifts or transfers to a custodial account are irrevocable, which means they can’t be withdrawn for any purpose other than costs that directly benefit the minor. For instance, a parent could use UGMA or UTMA money for the beneficiary’s private school, college, or healthcare.
Whether you're like Teresa and discover you own assets in a UGMA or UTMA account or have a different unexpected windfall, here are six steps for managing it wisely.
Step #1: Identify the purpose of your money.
Before making decisions about a cash windfall, you must identify its purpose. For instance, do you need it for short-term expenses, like buying a car or boosting your emergency fund? Or should it be set aside for your long-term goals, such as buying a home or retiring?
Though we tend to use the terms saving and investing interchangeably, they're different. Savings are for emergencies and significant purchases you want to make within a year or two. That money should never get invested because there's a risk its value could decline in the short term. Always keep your savings in an FDIC-insured bank or money market account to preserve it.
However, funds you need for longer-term goals three or more years in the future, such as buying a home, paying for a child's college, and, of course, retiring, should be invested. Yes, investing involves some risk, but without it, you aren't likely to earn enough growth to achieve significant goals like retiring.
Teresa, you didn't mention the value of your UGMA or UTMA account or anything about your financial situation. However, what you should do with a windfall depends on how you plan to spend it, so identify its purpose first.
Step #2: Review your financial safety nets.
Once you know how you'd like to spend a windfall, be sure you have financial safety nets in place. For instance, do you have enough cash in the bank? That's essential for managing unexpected expenses and hardships, like losing your job, making home repairs, or paying medical bills. Plus, a healthy emergency fund can be the ticket for staying out of debt when surprise bills pop up.
Teresa, a good cash reserve target is three to six months' worth of your living expenses (housing, food, utilities, and debt payments). For example, if your living expenses total $4,000 monthly, consider keeping from $12,000 to $24,000 in FDIC-insured savings.
Another safety net you need is insurance, such as health and life policies. Even a quick trip to the emergency room for an illness or accident could cost thousands of dollars. Being uninsured or underinsured could leave you financially devastated after an accident or illness.
Plus, if you have family members depending on your income, you need life insurance to protect their financial futures. So, if you don't have an ample cash reserve or the proper insurance, it's critical to use a windfall to shore up your financial defenses before spending it on anything else.
ALSO LISTEN: The Right Amount of Emergency Money to Keep In Cash
Step #3: Choose the best investment accounts.
Teresa asked if she should keep her UGMA or UTMA money as-is or transfer it to a different account, such as a Roth IRA, brokerage, or high-yield savings. Custodial accounts are brokerage accounts, so it’s possible that Teresa already has a menu of investment options to suit her financial goals.
But perhaps Teresa wants to consolidate the funds by transferring them to another brokerage account she owns. Once you’re the legal owner of a UGMA or UTMA, you can do anything with the assets you wish.
One consideration is whether you must sell your investments and transfer the cash proceeds to a new brokerage, or if an in-kind transfer between brokerage accounts is possible. That would make it easier to switch accounts and avoid the potential tax consequences of selling investments. However, what’s possible depends on your assets and what a new brokerage would permit.
Teresa mentioned having a Roth IRA, which is an excellent vehicle for after-tax funds, like her UGMA or UTMA investments. Once inside a Roth IRA, they grow tax-free for retirement with no required minimum distributions. Plus, you can withdraw Roth IRA contributions anytime; however, your account growth would be taxable and subject to a 10% early withdrawal penalty before you reach age 59.5.
Unlike a Roth IRA, funds in a brokerage account can be tapped anytime and for any reason. Another downside of a Roth IRA is that you're subject to annual contribution and income limits. For 2023, you can only put up to $6,500, or $7,500 if you're over 50, in a Roth IRA.
In addition, you're ineligible to make Roth IRA contributions when your modified adjusted gross income exceeds $153,000 if you're single or $228,000 if you're married and file joint taxes. Teresa didn't mention her income, but if she doesn't top those income thresholds, she can contribute up to $6,500 to her Roth IRA for 2023. You have until your tax filing deadline in 2024 to fund an IRA for 2023.
ALSO READ: Too Rich for a Roth? 3 Legal Ways to Have One
Step #4: Create a diversified portfolio.
You must choose specific investments once you have funds in a retirement account or a brokerage. If Teresa's UGMA or UTMA assets are with a firm like Vanguard or Fidelity that offers excellent investment choices, she may want to keep her money there. But moving her money may be wise if she doesn't have good options, like mutual funds, index funds, or exchange-traded funds (ETFs).
Teresa, whether you put money in a retirement account or brokerage, your goal should be to create a diversified portfolio using one or more of the following funds, which are made up of hundreds or thousands of underlying securities:
A diversified portfolio allows you to earn higher average returns while reducing risk. If some securities within a fund lose value, some will hold steady or increase in value, minimizing potential losses.
Step #5: Consider your risk tolerance.
While stocks can be volatile, the stock market's historical average return has been approximately 10% since the 1920s. So, if you're decades away from retirement, with plenty of time to recover from temporary market downturns, most of your portfolio should be in stock funds. However, if you're close to retirement or already retired, a more conservative approach is essential to minimize risk and preserve your wealth.
In general, stocks are one of the riskiest investments because their value can change daily; however, they offer the highest returns. Bonds are less risky because they offer a fixed but lower return. And cash or cash equivalents, such as money market funds, give you the lowest but safest returns.
Consider this: If you invest $500 monthly for 30 years at an average return of 3%, your balance will grow to about $250,000. Investing the same amount over 30 years at a 10% return would give you over $1.1 million, a difference of $850,000 to spend in retirement!
The bottom line is that If you invest too conservatively, you aren't likely to lose money, but you won't earn much either. But if you choose risky investments, like individual stocks, you can make a high return, but you may lose money—especially in the short term.
Step #6: Get investment advice when you need it.
Getting a significant windfall like a gift or a boost in your income is a fantastic opportunity to improve your finances that you shouldn't squander. If you're unsure how to manage it or choose investments, get advice from a professional, such as a certified financial advisor, tax accountant, or retirement planner.
And if you don't understand a financial pro's explanations or recommendations, keep asking questions until you do. You'll be glad you did, especially when you build a healthy nest egg that gives you peace of mind and financial security.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.