It’s not unusual to daydream about an unexpected windfall. Whether this is from a lottery win or an inheritance from a long-lost relative, we all have ideas about how we would spend the extra money.
But taking a little time to plan means that the money can be enjoyed for longer. A new car or a holiday might improve your immediate lifestyle, but probably won’t help you achieve your long term goals.
Types of Lump Sum
Your priorities for your lump sum will depend on the amount and where the money came from. For example:
- A redundancy payment may be needed to cover your costs until you can find a new job.
- A small cash prize could be put to best use repaying debt, topping up your cash reserve or paying for home improvements.
- A lottery win will be life-changing, and needs to be carefully managed to ensure that it’s not spent within a few years.
- An inheritance can come with grief and a sense of responsibility to use the money prudently.
- A business or share sale is usually the culmination of many years of hard work. You may be reliant on the proceeds to fund your retirement.
- An insurance or compensation pay-out may be required to pay for care or major lifestyle adjustments in the event of death, illness or injury.
After you have covered some immediate costs and potentially a few treats, you should start thinking longer term.
1. Keep Some Cash in the BankBuilding up a cash reserve is not an exciting use of the money, but it should be a high priority. You should aim to keep at least 3-6 months’ worth of essential expenses in a savings account, separate from the money you dip into regularly. This has the following benefits:
- No need to access credit for unexpected bills or repairs.
- It provides a safety net if you are unable to work for a short period.
- It helps to avoid stress, as regular bills and costs can still be covered, even in a particularly expensive month.
While it’s inevitable that you will dip into your reserves at some point, it is worth topping this up as cashflow allows.
2. Repay Debt
Some debt is useful. For example, if your mortgage is on a low interest rate, you may feel it is more worthwhile to invest the money than to clear the debt. This will depend on your circumstances and how you feel about the risks of investing versus the certainty of repayment.
Other debts are usually more expensive, and should be repaid as soon as possible. Not only are you paying interest, but there is also an opportunity cost. Your monthly repayments could be invested elsewhere and earning growth.
Remember, your circumstances can change at any time. Clearing debt not only reduces your outgoings, but also your vulnerability if things go wrong.
3. Top Up Your Pension
A pension is an extremely tax-efficient investment. Investing in a pension has the following benefits:
- For every £80 you contribute, a further £20 is credited to your pension in the form of tax relief (subject to certain limits).
- Higher and additional rate taxpayers can claim additional relief via Self-Assessment.
- The money in your pension grows free of tax.
- At retirement (or even earlier, providing you are over 55) you can withdraw 25% of your pension as a tax-free lump sum.
- Your remaining pension will be taxed at your marginal rate, but can be drawn flexibly as you wish.
- Pensions are not subject to Inheritance Tax, and can be passed on to your beneficiaries in full if you die before age 75. After age 75, beneficiaries can still receive your pension fund, but will pay tax at their own marginal rate.
- Redundancy payments are generally taxable over £30,000. Placing the excess in a pension can reduce your tax bill for the year.
However, there are certain caveats to be aware of:
- Personal contributions are limited to the higher of:
- Your gross earnings for the tax year
- Additionally, an annual allowance of £40,000 applies, which includes personal and employer contributions. However, any unused allowance can be carried forward by up to three tax years.
- Higher earners and those who have already withdrawn money from a pension may face additional restrictions. Advice is recommended.
- The minimum age to take pension benefits is 55, however this is rising to 57 in 2028 and will remain 10 years below the State Pension age.
4. Invest for the Future
If your pension is fully funded, or you want to be able to access your funds earlier, you may wish to consider other investment types. The main options are:
- ISAs – You can contribute up to £20,000 to your ISA each tax year. This can include cash, stocks and shares, or a combination of both. All returns are tax-free and you can withdraw your money without penalty or tax.
- Investment Accounts – This allows you to invest in many of the same investment options as your ISA, however without the tax benefits. Income and gains are taxed as they arise, although careful management and use of allowances can help to minimise this.
- Investment bonds – These can be based in the UK or in offshore jurisdictions such as the Isle of Man. No personal tax is payable while the money is invested, although UK bonds deduct a small amount of tax within the funds. You can withdraw your original capital without tax (up to 5% per year) and will eventually be taxed on the profit if you encash the bond. Bonds are ideal for gifting or placing in Trust.
The best investment option will depend on your circumstances and how you plan to use the money.
5. Provide for the Next Generation
With your own goals fully funded, you may be thinking about how best to provide for your family. You have a number of options:
- Gift money outright. Most gifts will remain in your estate for seven years.
- Smaller gifts of up to £3,000 per year are immediately exempt.
- If you received the money from an inheritance, you could enact a Deed of Variation within two years. This allows the money to be passed to someone else, bypassing your own estate completely. You can appoint an individual or a Trust as the new beneficiary.
- There are several options for placing money in Trust. These vary in terms of flexibility and tax efficiency, but broadly allow you to ring-fence funds for your beneficiaries without giving up full control. Trusts can be extremely complex and advice should be obtained.
Whatever your goals, a clear plan can help you make the most of your windfall and ensure that the money works for you.
Please do not hesitate to contact a member of the team to find out more about how to deal with an unexpected lump sum.