My daughter, Senay, has found an apartment at the University of Florida. Nowadays, it's not as common to stay at a dorm as a freshman. It's a really nice facility. It features a pool and an outdoor common area where you can play frisbee or cornhole, or just relax in the sun. Sadly, there is no pickleball court (lots are nearby).
She has her own room, bathroom, and even a balcony. The apartment is close to campus, and she can walk to class in fifteen minutes. UF has a cool downtown with many restaurants and coffee shops.
When I went to Penn State, I shared a bathroom with four other guys in a two-bedroom apartment built in the 1950s. It was freezing cold most of the time, and I had to trudge thirty minutes through the snow and gloom to get to class (uphill both ways). The only game we played was throwing a football in the narrow, dimly lit hallway outside our door. Our food options were limited, and we often resorted to canned beef stew and ramen noodles.
Above are the two apartments for comparison.
Let’s play a game. Let’s say your employer walks up to you today and says, "You have done such a good job for us this year. We are going to give you a $1,000,000 bonus." You’re suddenly a millionaire!
"That’s quite kind of you," you may reply.
Now, a million dollars sounds like a lot of money, and it would be a good reason to celebrate at a nice restaurant. As someone who has seen many people receive financial windfalls, let’s take a look at what often happens.
Important Note: The following story pertains to someone who is working with a good financial planner. In reality, most people in this situation would start to live a crazy lifestyle consisting of new homes, country club memberships, and boats. They would lavishly spoil their extended family with gifts. The money would be gone in a matter of months, and their new lifestyle would be impossible to maintain. Usually, they end up worse off than ever.
With that being said, let’s look at a more responsible scenario.
First, sadly, you have to pay taxes on the money. Since it is coming in the form of income, you need to pay federal income taxes. If you are married and make over $693,000, you are in the highest possible tax bracket, which is currently 37%. Remember, we operate under a progressive tax system, so only the portion between $693,000 and $1,000,000 would be taxed at that level. The rest would be taxed at lower rates. Let’s say, overall, you end up paying 30% in taxes.
Now you are down to $700,000.
"But, wait," you may say, "aren’t there ways to save money on taxes?" Good question. If this were me, I would immediately max out my 401k, which is $30,500 if you are over 50. If you both work, that would total $60,100. This means you have to pay taxes on only $940,000. You can also each put $7500 into a traditional IRA.
By maxing out your 401ks and IRAs, you just saved yourself nearly $30,000 in taxes.
Are there any other ways to reduce taxes? I’ve looked far and wide, and the answer, sadly, is "no." You can get really fancy and start buying into oil and gas partnerships or real estate investment trusts, but it isn’t worth the risk.
Of course, you should pay off any credit card debt. Some of the rates these days are outrageous. Even if you start moving your debt from credit card to credit card (to get low rates), you are only pushing off the inevitable 28% interest. If you don’t have any life insurance, you will get some.
What would you do next? Many people decide to pay off their house. Many of you with mortgages pay between 2.5% and 4% (unless you recently purchased a home), so I caution you before writing a big check.
Let’s say you owe $200,000. Yes, having that mortgage paid off will feel great, but you just paid off very "cheap" debt. You could take the same $200,000, put it into a CD, and get 5%. It could be argued that you are losing money by paying off your mortgage (weird). If CD rates get really low again, you can pay off the house then. You have total flexibility and control.
An even more significant consideration is that you are losing a ton of liquidity by paying off that house. If you even need that money back, it is more complicated. You must get a home equity line of credit or a new mortgage. Cash is king. I would rather have accessible cash than a paid-off low-interest mortgage. Of course, you could always invest it in a diversified stock portfolio, which should return 8-10% over time.
Next, you might buy yourself that dream car. This is trickier from a financing perspective. In today’s environment, you would be looking at 6%+, which I don’t like. But, hey, you just got a million bucks, so you take the plunge and buy a new BMW 6 Series Convertible for $90,000.
Now what? A vacation is in order. How about a luxury, two-week tour to Europe for $30,000? You deserve it, right? It’s not too often your employer is so generous.
Now that you think of it, you’ve always wanted to redo your kitchen. You have the money, so you might as well do it up right. A new kitchen always increases the home’s value anyway, you rationalize. So, you get a few quotes and plunk down $70,000.
Of course, your loved ones deserve a little something from this windfall. Unfortunately, word somehow got out that you are flush with cash. A few family members approach you in dire need of funds. How can you say "no"? They are flesh and blood.
Again, in this scenario, let’s assume you have some financial sense. You do not have the urge to buy fancy jewelry; you will not buy a $200,000 RV or a $250,000 boat.
So what’s left? Probably around $200,000, more money in your retirement account, a new car, and a paid-off home (with a nicer kitchen). If you invest $200,000 in a portfolio of stocks and bonds, you can safely withdraw $800 monthly as retirement income.
What is my point in this whole exercise? Being a millionaire isn’t quite the same as when you were a kid. But, at the same time, this sounds like a lot of fun. If you take a minute to breathe and plan, you can have a blast with the money more intelligently, leaving you in a better overall financial state.
If you encounter someone with a financial windfall like this, make sure they talk to someone like me before they do anything. It could be the difference between decent financial security and bankruptcy. I wish I were exaggerating, but I’m not.
Be Blessed,
Dave