What should you do if you receive a windfall?
Many people at some point in their life receive a windfall, perhaps from an inheritance, a redundancy payment or even a Lotto win.
People in this situation are often caught by surprise, especially if they have not previously had access to a large windfall.
The risk is the money won’t be wisely invested or worse, squandered. This means it’s important to carefully plan the best way to make the most of any unexpected financial gain.
Darren Howard is a specialist self-managed super fund (SMSF) financial planner with Merit Planning East. He says the first step after a windfall should be to eliminate non-deductible debt as much as possible.
“Start by paying off loans with the highest interest rates, progressively moving down to your lowest interest rate options. Typically you would get rid of credit card debts and personal loans first as interest rates on these debts can be north of 10 per cent,” says Howard.
“If you've cleared your non-deductible debt it gives you more capacity to look at other wealth creation strategies such as gearing. If you paid off all your non-deductible debt, you could redraw that and gear into property or equities, investments that run alongside superannuation wealth creation strategies,” Howard says, explaining that this is a good strategy for people who have already contributed the maximum amount to their super fund.
The reason why setting up a strategy to gear against an existing asset like the family home may make sense is because investors can offset the borrowing costs against the tax they pay.
Investing it an SMSF
For investors who still have capacity to contribute to their super fund he says one approach is to drip-feed the windfall into the fund over time. Let's say a husband and wife in their 50's receives a $500,000 windfall. The couple might gradually contribute the money into an SMSF over a 10-year period.
“They might make a $50,000 contribution each year until they reach 60, when they can access they money,” he explains, noting that gradually moving assets that are in less attractive tax structures into an SMSF helps investors maximise the tax benefits of the super environment.
Liquidity and flexibility are other benefits of this strategy. For example, if the couple contributed the full $500,000 to their account immediately, although it remains a tax effective investment, they can’t access it until they turn 60.
“By drip feeding it in they retain flexibility, at the same time gradually transferring the money from a less tax-effective environment to a very attractive tax environment. They are still able to contribute all the funds to their super account by the time they reach 60, but have liquidity and flexibility along the way,” says Howard.
Goals and risk profile
Once initial decisions about how the money should be invested have been made, it’s important to ensure it is properly managed on an ongoing basis. What this will look like depends on the investor’s goals and risk tolerance.
“It comes down to making sure you have an appropriate asset allocation compared to your risk profile. Typically, that will mean making sure you are diversified across the main asset classes such as cash, fixed interest, property and shares. After that it’s also important to make sure you are taking advantage of all the tax-effective strategies that are available to you,” says Howard.
He reminds SMSF investors that there are five main tax benefits that are available to Australian investors. The first, superannuation, is still the most tax effective structure available.
Salary sacrificing, which involves contributing a portion of your salary on a pre-tax basis to a complying superannuation fund, is also a tax-effective strategy. But the effectiveness of this strategy is now less than in the past, assuming legislation to lower the concessional contribution amount to $25,000 a year is passed in parliament.
Franking credits, which lower the tax investors in equities that offer franking credits pay, are a very attractive option that applies to most Australian shares. Negative gearing is another strategy that remains in place to help investors minimise the tax they pay. Finally, the family home is a capital gains tax-free strategy.
Says Howard: “As retirement gets closer, many investors who may not have allocated enough or much money to superannuation over the years do have the opportunity to sell their property and make a tax free gain, downsize and buy a property of lower value and move the remaining proceeds into their SMSF at or near retirement. That’s also a strategy that could be used by someone who receives a windfall.”
There are a number of approaches people who receive a windfall can take to ensure they protect their new-found wealth. The idea is to take your time and ensure the money is invested taking into account your risk profile and the investment goals.
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