FOOL'S EYE VIEW
How To Invest A Windfall

By Cliff D'Arcy
September 11, 2003

One thing that very few of us would refuse is a large cash windfall. However, unexpected bonuses, gambling wins (on the Premium Bonds or the dreadful National Lottery) and inheritances from long-lost relatives often come with their own problems attached...

Although UK gambling wins are tax-free (you lucky devils!), a large bonus from work could push you into the 40% tax bracket, which kicks in at roughly £35,000. This could mean paying extra tax on your savings (and dividend income outside of ISAs or PEPs), from which tax is usually deducted at 20% and 10% respectively.

What's more, an inheritance may come with strings attached: as well as being a beneficiary, you may also be an executor of a Will, which means taking responsibility for settling someone's estate. This can be quite involved, so you may end up earning your inheritance! (For more on Wills, Probate and estate planning, read this excellent advice from Mark Goodson.)

In addition, when you do come into a relatively large sum of money, you have to decide what to do with it. Of course, what's best for you very much depends on your age, personal situation, current and future needs, and your attitude to risk. Nevertheless, here's some general advice on making the most of your newfound fortune.

1. Pay off expensive cards and loans

This is the Golden Rule. There's no point in having savings or investments if you're also carrying expensive debts on store cards, credit cards, store credit, personal loans and so on. By using all or part of your windfall to pay these off, you'll effectively be making a return of anything up to 32% a year. That's a lot better than any mainstream investment.

2. Decide if you want to have a mortgage

If your lump sum is large enough, you may want to repay some - or all - of your mortgage. This is an attractive option if you're looking for a guaranteed, low-risk way to reduce your debt and boost your disposable income. Alternatively, you may be able to make greater returns from investing your capital, but this is by no means certain.

For example, if your mortgage rate is 5% and you pay basic-rate tax, an investment would need to earn more than 6.25% (that's 5% divided by 0.8) after 20% tax to give you more in your hand than paying off your home loan would. For those paying 40% tax, this 'hurdle rate' is 8.33% (5% divided by 0.6). These days you can't earn this much with risk-free investments, such as cash deposits, so your capital would probably end up in bonds or shares. This means that its value would vary over time.

3. Give yourself a cash cushion

If you don't have three to six months' salary on deposit as an emergency fund, stick some of your windfall on deposit in the highest paying savings account you can find. If you're a taxpayer, you can avoid paying tax on interest by putting up to £3,000 a year into a cash mini-ISA, the best of which currently pay tax-free interest of around 4% a year. Here's one of the Best Buys.

4. Plan ahead: put money away for the long term

If you're saving for less than five years, stick to deposit accounts. However, if your horizon is further off (such as putting money aside for children or retirement), you should consider investing in shares. Low-cost, flexible, easy-to-understand index trackers and investment trusts are two products that allow you to buy a portfolio (or basket) of shares cheaply.

To protect your income and gains from the taxman, put a tax-free ISA wrapper around your tracker or investment trust. If you don't have a cash mini-ISA in one tax year, you're free to put up to £7,000 into a shares maxi-ISA.

5. Top up your pension

If you're a basic-rate taxpayer, dropping a lump sum into your pension would produce an extra handout from the taxman. For example, if you toss £2,000 into a personal or company pension, the government will add £564 in tax relief, making your total investment £2,564. That's instant growth of 28.2% before charges.

For those paying 40% tax, the rewards are even greater: £2,000 is magically turned into £3,333 - instant growth of two-thirds (66.7%) - wow!

If you belong to a company scheme (either final salary or money purchase), check to see what additional voluntary contributions you can make. For example, at the end of every tax year, my wife chucks as much of her company bonus as the taxman allows into her company pension scheme. This brings down her tax bill and provides a major boost to her retirement pot.

6. Buy your home or become a landlord

You may decide to buy your own home, which is generally a good idea, as history has shown. Then again, if you already own a home, you may decide to buy a property and rent it out. This is very popular at the moment, but it comes with its own risks and hassles, so you need to make your own mind up as to whether you want to attempt to make money from property.

7. Take tax (and death) seriously

A sizeable windfall could provide a big enough boost to your income to push you into a higher tax bracket. There's some good advice on reducing your tax bill in this article.

Even worse, your windfall could be large enough to push you over the £255,000 threshold for inheritance tax (IHT). If you kick the bucket and leave assets worth more than this 'nil-rate band', you'll be clobbered for tax at 40%. So, leave £355,000 in total, and your estate will be hit with a £40,000 bill for IHT - ouch! Here's a brief guide to avoid paying what is frequently described as a 'voluntary tax'.

8. Don't take the plunge straight away

Before you go rushing into a spending or investing binge, take some time to sit back and work out what you want this money to do for you. If you blow it all in a whirlwind spree, you'll probably end up regretting it. The same goes for investing: you don't have to put your money into the market as a one-off payment. By drip-feeding money into the stock market over months or years, you'll avoid investing all your money during a short-lived peak in the market, and make the most of your annual ISA allowances.

Finally, whatever you do with your windfall, take a moment to thank your lucky stars and the person from whom it came. You never know if you'll ever have a similar payout again!

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