Chapter 22
Investing Lump Sums

In This Chapter
  • Understanding the challenges of investing lump sums
  • Striking a balance with your income tax
  • Putting severance pay to work for you
  • Stock options, settlements, and inheritances
  • Using dollar-cost averaging to reduce risk and increase your wealth
  • Knowing enough to ask for advice
  • What to do with retirement lump sums?

Saving and investing money normally is done in a systematic manner, a little bit at a time. You contribute some of every paycheck to your 401(k). A bit more goes into your daughter’s college fund. Still another piece goes toward your emergency fund. Little by little, you build up the accounts.

There’s a good chance, however, that at one point of your life or another, you’ll receive a significant amount of money—all at once. It could be an inheritance, a tax refund, a bonus, or severance pay. However you get it, a lump sum of money can be a challenge.

What do you do with it? You could take your family to Disney World, or you and your spouse to a romantic, secluded island. You could do that remodeling you’ve been putting off, or finally buy yourself that little boat you’ve always wanted.

Or you could invest the money. Granted, that doesn’t sound like nearly as much fun as the other options, but it’s a smart move.

The very best thing you can do with a lump sum, regardless of where it comes from, is to pay off high-interest debt (that means credit cards). Investing money at 10 percent is great, but it doesn’t make sense to do that if you’re paying 18 percent on $10,000 worth of credit card debt. Pay that first, and then consider your options.

Tax Refunds

While it seems that most of us middle-aged folks end up owing taxes in April instead of looking forward to refunds, there may be circumstances under which you’ll receive a tax refund.

If you’re getting substantial tax refunds, it’s because you’re having too much withheld from your paycheck. You may be able to cut your withholding rate and increase your take-home pay, allowing you to invest the money throughout the year.

If you got a tax refund this year of $3,600, and you’re paid every two weeks, you received $138 less per pay period than you should have. That’s money you could have invested in an interest-bearing account, or used to help out with the bills.

Having said all that, if you do get a tax refund, you’ll need to decide what to do with it.

Go Figure
George W. saw to it that we all got a lump sum recently in the form of immediate tax relief. Most Americans who pay federal income tax received between $300 and $600 in 2001, courtesy of the U.S. government.

The best thing, obviously, if you don’t have credit card or other high-interest debt, is to invest the money. You could add it to a college fund, or buy some stock in what you hope will be the next Microsoft. Saving is better than spending, although the government and retailers count on us spending those tax refund checks as a means of jump-starting the economy.

If you just can’t sink the entire check into savings, let’s at least reach a compromise. Invest part of it, then spend the rest. And have fun.

Severance Pay

We spent a good bit of Part 4, “Life Changes,” discussing job layoffs and downsizing, so we won’t get into it here in much detail. Just remember that no one is ever really safe from the possibility of losing his or her job. And, keep in mind that losing a job can be extremely difficult, both financially and emotionally.

If your employer does hand you a pink slip; however, hope and pray that there’s a check along with it. Severance pay can ease the pain of losing a job because it gives you some financial security until you can find other employment.

Being suddenly without a paycheck is a scary situation. Having some money, up front, to tide you over can help make life a lot less scary.

[image] Money Morsel
If your company doesn’t offer you any severance pay, ask for some. You’ve already been fired, what can it hurt? Some employers would offer something in hopes of eliminating any possibility of a lawsuit.

Many companies offer a severance package of a week’s pay for each year of service, plus unused vacation, sick, and personal time. It’s often presented as a lump sum.

If you receive a severance package, think carefully about what you’ll do with it. If you’re not confident that you’ll soon find another job, and you don’t have much emergency money put aside, chances are you’ll need to dig into your severance in order to keep paying your bills. Unemployment compensation helps, but it doesn’t pay you the full amount that you had been earning. If you’ve got a lot of bills or other expenses, keep your severance pay accessible in case you need it.

To keep the money available, you can open a designated savings account at the bank. Don’t add the money to an existing account; it’s better to keep it separate. Or you could open a money market fund with a mutual fund company. Although the rate on money market funds has been low recently, they do have some decent earning potential, certainly higher than your savings account and they keep your money accessible.

If you find, however, that between your unemployment pay and other sources of income, you don’t need the severance money, you’ve got a nice opportunity. You probably should still keep the money available until you begin a new job and resume getting a paycheck. Once you’re back at work, however, you could use the severance pay to wipe out a car bill, reduce your mortgage, or have the roof fixed. Once you’ve done those things, invest any money left over in a college or retirement fund.


Bonuses can be a once-in-a-career bonanza, or an annual event for employees. One-time bonuses aren’t too common, but, if you get a big check (or even not-so-big) that’s a once in a lifetime situation, enjoy it. And don’t forget to follow the recommendations noted throughout this chapter.

Usually, employees who receive bonuses get them every year as a supplement to their compensation (pay). A bonus might be based on the performance of the employee, the company, or a combination. Regardless of how the bonus is determined, it normally arrives every year, usually around the same time.

[image] Don’t Go There
It’s always tempting to spend a lump sum outright, especially one that you weren’t expecting to have. Resist the temptation, however, unless it’s on something you really need. Once the money is gone, it’s gone.

Some employers pay out bonuses during the holiday season, hoping to generate good cheer and employee loyalty. Bonuses can be based on a percentage of pay, or represent a fixed pay period (i.e., two weeks’ pay), so that the funds received by the employees are proportional to their salary.

Some companies offer bonuses only at the corporate level, and base them on whether or not the firm and its employees have reached pre-determined goals.

Go Figure
Financial planners estimate that 55 percent of Americans don’t have an emergency fund.

If you’re anticipating an annual bonus, remember that it’s only anticipated until you’ve actually got it. Don’t ever spend money before you have it, anticipating being able to pay it back. Employers are not obligated to give bonuses, and you could be sorely disappointed—not to mention financially strapped—if you spend a bonus that never comes.

If you do get a bonus, and you don’t have high-interest debt to pay, consider putting it in your emergency fund. If you don’t have an emergency fund, use the money to get one started. Everyone should have such a fund as a buffer in case of job loss, disability, divorce, or so forth.

Many people, even those in their 40s and 50s, still live pretty much from paycheck to paycheck, with little money left over after meeting all the expenses. Even a major car repair can send them into debt, and a period of unemployment due to illness or disability can be devastating. If you don’t have dental coverage and have ever needed a couple of crowns or a root canal, you know how expensive taking care of your teeth can be.

Most experts recommend that you have an emergency fund of at least three months’ income, and preferably up to six months’ income. A bonus would be a great way to supplement your emergency fund, or to get one started if you haven’t already. If you’ve already got a sufficient emergency fund established, bonus money can be saved or invested.

Just as a point, many people, us included, use the words “save” and “invest” interchangeably. While saving money in a bank account technically is investing it, there’s really a difference between saving and investing.

Saving money is storing it safely away (not under your mattress, please!) for short-term needs, or for a specific purpose such as your daughter’s wedding or your parent’s fiftieth wedding anniversary party. Investing, on the other hand, is a longer-term process that involves risk.

A bonus is, indeed, just that. It’s extra money, and often unplanned. Using it wisely to start or supplement an emergency fund is a great investment in your future.

Stock Options

Stock options used to be primarily given to the big shots within a company, but more and more businesses these days are offering stock options to nonmanagement types as a means of attracting, retaining, rewarding, or providing incentive to employees.

An employee stock option allows you to buy shares of stock in the company for which you work at a specified price, and over a period of time. Normally, you’re required to hold the stock for a certain amount of time.

Let’s say you’ve landed a job with Mapquest, the Internet site that gives you directions from one location to another and provides other information and services. You’re offered Mapquest stock at $1 a share until August 2002. When August comes, the stock is valued at $25 a share. If you exercise your stock option, the difference between the $1 and $25, less taxes, is yours.

Be aware, however, that the alternative can happen. Some friends own option shares of K-Mart at $22 per share, set to expire in August 2002. Unless K-Mart is doing significantly better by next year, these friends will be stuck with bad stock. K-Mart stock is currently valued at about $9.50 per share—making that option one you don’t want to exercise.

You normally are required to keep the stock options for a specified holding period. If the value of the stock increases during that holding period, you should purchase the options shares and take the gain.

The gain may be considered current income, or capital gain income, depending on whether you held the option shares for more than a year.

Stock options can be tricky, and it’s a good idea to get some advice from a financial consultant if your options are significant. If you get a lump sum when you exercise your stock options, an advisor can tell you how to best reinvest the money.


If you find yourself in possession of a lump sum of money due to settlement on a lawsuit or a contract, your first order of business should be to evaluate your needs.

Many people have settled lawsuits from which they received compensation for injury that occurred in an accident. Thrilled to have the money, they go out and buy a new car or some other expensive item or items. Too late, they realize that they don’t have enough money to cover ongoing, uninsured medical expenses.

Go Figure
Research shows that people who make at least $15,000 a year generally are happier than those who make less than that. It also reveals, however, that those who make $75,000 or more a year are no happier than those who make $25,000. So if you’ve got a lump sum heading your way, enjoy it, but don’t expect it to solve all your problems and make you a happy person if you aren’t happy already.

Lawyers for the defendant in a settlement case sometimes will request that a settlement be paid in monthly payouts (via an annuity) to the claimants in a lawsuit. The annuity settlement provides a guaranteed income for the injured party for a set period of time, or perhaps even for life. This eliminates the need for the claimants to handle a lot of money all at once.

But more frequently, settlements, lottery winnings, and so forth are awarded in lump sums. This requires the receivers to find an investment manager, and plan an asset allocation to provide income and assure there will be money for future needs.

Dealing with a lump sum of money is difficult. You need to make a lot of decisions, and you’ll probably need a lot of help.

If you get a lump sum of money, be sure to allocate your assets. Decide how much you want to spend on stocks, or bonds, or whatever. Then, look into getting the most from your money by dollar cost averaging your investments.

Huh? Dollar cost averaging means that you invest equal amounts of money at regular intervals—usually each month.

[image] Adding It Up
Dollar cost averaging is based on the belief that the market, or a particular stock, will rise in price over the long term, and that it’s neither worthwhile, nor possible, to identify intermediate highs and lows.

Because you’re always investing the same amount, you can buy more investments when the price is low, and fewer shares when the price is high. As a result, the average dollar amount you pay per share is always lower than the average market price per share during the time you’re investing.

And, because your investments are made over a period of time, you can plan to buy big when the price is low, and slow down your spending when the price is high. As a result, the average market price per investment during the time you are investing should be more constant than if you go in all at one time.

Dollar-cost averaging is an easy, controlled way to build a significant investment portfolio. If you get a lump sum of money, and you’re not a seasoned investor, it may be the way for you to go. Dollar-cost averaging has proven to reduce risk and to help build investments over time.


Sooner or later, we all experience the loss of a loved one. And, while many people think it would be simply fabulous to inherit a million dollars from some long-lost aunt who they didn’t know or love, the truth is, receiving an inheritance is normally a very bittersweet experience.

Sure, who couldn’t use $25,000, or $100,000, or half a million, or five million dollars? When it comes at the cost of losing a parent, or a spouse, or a best friend, however, the money is not—at least for a while—a happy addition to your life.

Most people desire to leave something behind for their children and/or grandchildren. Perhaps it’s a natural tendency to want to continue to provide for those you love—even after death. That’s why clients spend hours with lawyers and financial planners, working to keep as much of their estates as possible in the hands of their families, and out of the hands of the government.

If you receive an inheritance, you’ll need to realize that it’s very different from a bonus, for instance. An inheritance is a gift. It’s not earned, in any way. This gift, hopefully, can provide some substantial security in your life.

Go Figure
Fully 20 percent of people 50 years or older who were surveyed said that an inheritance—or a lack of one—had caused hard feelings among members of their families.

We strongly recommend that you invest the entire inheritance, then use the income that the funds generate for the extras in life. Financial advisors call this the “not using principal” strategy. You invest the principal, and use the income you get from it for trips, toward a car, a bigger home, or whatever.

If you inherit $100,000, and invest it so you’re getting a five percent return, you’ll have $5,000 more per year than you did before you got the inheritance. If you receive more, your additional income will be more.

If you spend the money you get as inheritance, it’s gone. Many people have inherited $100,000 or $200,000 and, thinking they were wealthy because it was more money than they ever had before, went on wild shopping sprees that quickly left them broke. If you get a large sum of money, be sure to contact a financial advisor. You should never attempt to invest large sums on your own if you’re inexperienced.

Retirement Lump Sum Payouts

Whether you are changing jobs or are lucky enough to retire early, there will be several opportunities during your lifetime when you are presented with making decisions concerning a lump sum retirement payout. This might occur when you change jobs, and hopefully, you’ll roll the money over into an IRA or into your new employer’s 401(k) plan at work. Deciding whether to open an IRA or roll the funds into your new employer’s 401(k) was previously discussed in Chapter 20, “Investing at Work.”

This roll-over will continue the tax deferred growth of the funds, as well as guaranteeing you won’t have a penalty and income tax liability on the withdrawal until you actually retire.

So when we talk about lump sum payouts, we’re actually talking about the requirement or ability to take all your retirement funds from your employer’s plan when you actually retire. Although this might be a little premature for a discussion with people in their 40s and 50s, many people have the goal to retire at age 55. Maybe you’re one of the lucky ones who can do this.

Of course, you don’t want to take all the funds out of a retirement plan creating a horrendous tax liability. If you are required to or you want to take out the funds from the retirement plan, roll-over all the funds into an IRA held at your local bank or with a brokerage firm, then you can start to withdraw the funds needed to retire.

The rollover must be made from the company’s plan directly to the new account. If you don’t have a “trustee to trustee” transfer, your employer is required to withhold 20 percent in taxes. This money is held by the IRS until you file your return in April and is considered a distribution. Ouch! The withholding and withdrawals can easily be avoided by rolling over the funds directly to the new investment firm.

Once you’ve rolled the funds into a new account, you can set up monthly withdrawals or keep it building until you are ready to begin distributions at 5912 or later. The withdrawals depend on whether you have enough money on which to live without using the retirement funds.

When your retirement account was managed within your employer’s plan, your employer was watching the funds and making certain the fund choices were good. Once you leave their plan, the choices are yours and the problems begin.

First, are you going to handle investing the money yourself within a family of funds, a brokerage account, or are you going to find a financial advisor who will guide you through the process. It’s frustrating to see persons with $230,000 in retirement money hook up with a commission financial adviser who gets paid 5 percent of the value of the retirement account (that’s over $10,000) just to guide you into investing your funds within an annuity or mutual fund family.

So as we’ll discuss in the next chapter, look for a financial adviser who gets paid on an hourly basis to help you find a good place to invest your money.

There are pros and cons to investing in an annuity, but qualified retirement money should not go into an IRA annuity. IRAs are already sheltered from tax liability until withdrawn (the funds are sheltered from tax analogous to being sheltered by an umbrella). Annuities are also sheltered, but it’s like putting an umbrella over an umbrella and as you can only imagine, the internal fees of the IRA annuity are higher than just a mutual fund IRA.

An annuity is a contract between an insurance company and an individual that will provide periodic payments to the individual, or to a designated beneficiary, in return for an investment. Usually, the annuity agrees to provide payments to the purchaser (known as the annuitant) beginning at some future date. An IRA annuity is somewhat different because it must follow the IRA payout rules rather than the annuity rules. So if you have a lump sum payout, set up an IRA not an IRA annuity.

We’ve all been taught since we’ve been kids that you can’t withdraw from an IRA until you are 5912. Well, as usual, the IRA has exceptions to their rules. So if you retire at 55, and want to use your retirement funds, you can withdraw money from an IRA within a very limited set of rules. The IRS requires that you take a fixed periodic payment for at least 5 years or until you are 5912, whichever comes later.

That sounds like Greek, so we’ll give you some examples to clarify the rules. This is a very obscure and little known rule and it’s important for people who are forced to retire early or want to retire early. No one wants to pay more tax than they have to and no one wants to pay a 10 percent penalty on retirement money withdrawn before they are 5912.

If you retire at 57 and set up a monthly payout for five years, you won’t be able to change your payout until after age 62 since you need to take the fixed payment for 5 years. But if you retire at 52, you’ll need to continue the fixed payment for 712 years until your 5912 to guarantee you aren’t penalized for the withdrawals. Of course, the funds are taxed, but not penalized.

The monthly payout is calculated based on your life expectancy, similar to a minimum required distribution, so visit with a CPA before you use this interesting option.

Also remember when you rollover funds, that the total can be divided into separate accounts and the funds used differently. If you want to set up fixed payments, know they cannot be changed without creating a tax nightmare. Not once during the entire time period can you change the payout, so if you need more money, you’ll be penalized for all the years you’ve been taking withdrawals. Thus, it’s best to have another fund, either with other retirement money or preferably with nonretirement money from which to purchase a car or other needs.

The following are things to remember with a lump sum payout:

  • Roll-over, don’t withdraw your lump sum payout to prevent possible penalties, and certainly income taxation on the funds.
  • Use a “trustee to trustee” transfer of funds to prevent income tax withholding. This continues deferral on the funds until withdrawn.
  • Withdrawals before age 5912 can be accomplished without a 10 percent penalty, but within strict guidelines.
  • Review whether to stay with the same investment firm as your employer is using, or look for a fee only financial advisor to guide you where to move your money.
  • The total retirement fund can be rolled into various retirement accounts, to be used differently.
  • An IRA annuity has greater internal costs than just an IRA or just annuity.
The Least You Need to Know
  • Knowing how to invest lump sums can be challenging, even to experienced investors.
  • The best thing to do with a lump sum of money, if you have high-interest debt, is to use the money to get rid of the debt.
  • If you’re getting big tax refunds, you’re having too much withheld from your paycheck, and you should adjust your withholdings.
  • Severance pay that’s not needed for regular expenses is a perfect means for starting or adding to an emergency fund.
  • Never depend on a bonus or spend it in advance, even if you’ve always received it in the past.
  • Understanding stock options can be challenging, but they sometimes can result in significant financial gain.
  • Settlements, inheritances, and other lump sums can be invested using a dollar-cost averaging method, which reduces risk.
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