What to Do With a Lump Sum of Cash?

September 4, 2023  | By Kevin Smith

Having a pile of cash in the bank is usually a good thing, but it requires some stressful decision making. How much can we spend (YOLO!)? How much should we save? What about taxes? Should we pay down our mortgage?

The cash could be from a bonus, an inheritance, a business distribution after a profitable year, a gift, vested company stock, equity from the sale of property or a business, an insurance or lawsuit settlement, or even winning the lottery!

If you don’t have a plan, the money may disappear and, years later, you may be disappointed that you don’t have much to show for it. Here is a simple order of priorities that will help you balance enjoyment with responsibility. Don’t worry, you get to enjoy some of it now if you follow this plan.

Set aside for taxes

You may owe additional taxes on your lump sum of cash, depending on the source. If you get hit with a surprise at tax filing, and the cash is gone, you could have a problem. Let’s figure out your tax liability. Here’s a rough sketch, but definitely check with your CPA:

• Bonus – your marginal tax rate may exceed the amount withheld, so you may owe more
• RSUs (company stock) – your marginal tax rate may exceed the 22% standard withholding
• ESPP (company stock) – if you sell within a year of purchase, you will pay your marginal income tax rate instead of the long term capital gains rate!
• Business profit distribution – your taxable profit may exceed the amount you withdraw! This is a common unwelcome surprise. Coordinate with your CPA.
• Sale of business / property – if you owe capital gains taxes, a large sale could trigger a 20% or 22% tax rate, instead of the standard 15%. In some cases, you will pay your marginal income tax rate. Either way, taxes are not withheld for you, so you must handle the tax payment yourself.
• Inheritance – your tax liability will depend on the types of assets you inherit, many are tax free.
• Settlement/Lottery – talk to a CPA!

Set aside for big, unusual expenses in the near future

If you are planning on spending a big chunk of that money in the next year or two, it probably doesn’t make sense to take market risk (stocks and bonds). There are currently lots of great options for low risk cash-like investments with high interest rates. Each has tradeoffs to be aware of. Setting these funds aside in a separate account will prevent it from being used for a different purpose.

Examples of high yielding, low risk accounts for short term investments:

• High yield savings account (4%, FDIC insured)
• Money market account (almost 5%, risks are low but not zero)
• No penalty CDs (low 4%, FDIC insured)
• Treasury Bills (mid 5% with some market risk)

Examples of expenses/investments in this category:

• House down payment
• House remodel
• Business investment
• Real estate investment
• Education expenses
• Car

Pay off bad debt

Not all debt is bad, but some folks have a goal of zero debt, and we don’t try too hard to talk them out of it. Being debt free is a worthy goal, even if it means giving up some useful leverage. Generally speaking bad debt means:

• High interest rates (over 5%)
• Variable interest rates (rates that adjust up or down)
• Not tax deductible
• Not forgivable (some student loans can be forgiven under certain conditions)

If you have a lower interest rate loan with a high payment and low balance, it might make sense just to pay it off and find a more productive use of that cash flow.

Top off bank accounts

Each bank account should have a purchase and a minimum and maximum target level. This makes it easy to know how much of your lump sum you should put toward these accounts. Then you can more comfortably invest the excess. Here is an example of a simple cash management system:

• Checking: $10k minimum, $20k maximum (Higher maximum for households with lumpy cash flow)

• Savings: $0k minimum, $25k maximum (Varies by household, used to save in advance for vacation, big purchases, etc. The maximum should align with your annual budget for these big expenses.)

• Emergency: 3-6 months of living expenses (Primarily used as insurance for health or family emergency, job loss)

Invest it

If you’ve tackled everything above and you have cash left over, that means you have at least several years before you need to access it. Now you can more easily justify investing this amount. Which account you use and how you invest will depend on your bigger picture financial situation and your eligibility for retirement account deposits.

• Individual or Joint Brokerage Account – for access before age 60
• Pre-Tax Retirement Account – for access in retirement, lower your taxes now
• Roth Retirement Account – usually for access in late retirement, lower your taxes later
• Annuity / Cash Value Life Insurance – usually only make sense if you have maximized all of the categories above, of if you have a specific need

Another consideration is when to buy into markets. To reduce the chances of having the bad luck of buying just before a crash, and to give yourself a chance to take advantage of a falling market, we prefer a ‘dollar cost averaging’ strategy. This means committing to invest at regular intervals over a period of time, and we can even include plans to buy more if the market falls significantly.

Having a clear plan increases the chances of actually buying assets when they are on sale, which is very difficult to do otherwise. Very few investors feel good about buying after the market has declined -25%, even if they believe it is in their interest. Imagine having a lump sum to invest in January 2020, just ahead of the pandemic. Having a plan reduces the stress of investing and helps increase the odds of success.