Misusing a financial windfall

Often, clients come to see a financial adviser following the receipt of a windfall. This might be an inheritance, a redundancy payment, or even prize money in cash or kind. For many, this is the first time that they have had such a large amount of cash, and they seek advice as to what to do with it.

In the ‘old days’ of commission-based remuneration, this usually led to a financial planner recommending that the windfall, say $50,000, be used to purchase an investment in some form of managed fund. This purchase triggered a commission for the adviser, which paid for the advice, and helped the client establish a wealth-creation strategy.

In many cases, though, it was not the best use of the windfall. For any client who pays tax, there will almost certainly be better uses for a windfall. One simple one, for clients with a private home loan, is to use the windfall to pay down this non-deductible debt. Depending on their tax rate, this will earn them the equivalent of a pre-tax income return of up to 1.8 times the interest rate for the loan. And, because debt is being retired, the capital being ‘invested’ is guaranteed. This is almost certainly the best blend of risk and return available.

If clients do not yet have a home loan, but plan on getting one, then the windfall should usually be ‘parked’ in some non-volatile setting (such as a term deposit) for use as a deposit, where the eventual effect will be the same as paying down debt.

If clients still want to diversify into a managed fund or other form of investment, then they can of course still do this. But they are best off using the windfall to pay down their non-deductible debt and then drawing a second, separate loan (which may still be secured against their home) to use specifically to finance the investment. The interest on this investment is deductible, which has the effect of reducing the effective interest rate by whatever the marginal tax rate is.

For working clients who don’t have a home loan, then the windfall is often best used to fund living expenses. The client then organises for an equivalent amount of pre-tax salary to be contributed into super. For example, if a client receives $50,000 and pays tax at the rate of 37%, they must earn almost $80,000 to be left with $50,000 after tax. If the client decides to increase their deductible super contributions by, say, $20,000 a year for four years, the $80,000 sacrificed into super will only incur $12,000 in tax. This leaves them with $68,000 in their super fund. This represents a whopping, immediate guaranteed return of 36% on the $50,000, which can then compound in the tax-advantaged super fund.

So, when any tax-paying client receives a windfall, think tax-effect first.

The Dover Group