The lottery test

If you won $10,000 in a contest, what would you do with your good fortune? What if it were $500? Or, what if it were $1,000,000? How you answer says a lot about you and what value you place on money. While you're probably thinking Mr. Tom would say if you don't save it all, you're making a poor financial decision, that's not always the case, as I'll explain. I would start by asking: Did you evaluate how the winnings could provide the best financial result for you now and in the future?

Let's say you're in your late 30s with almost no retirement savings and no debt. Then, the best choice would be to put the $10,000 into retirement savings as a lifetime savings boost that makes up for some earlier years when you didn't save enough for retirement. Same with $500. But if getting $1,000,000 - after paying taxes - you would make a plan to fund retirement contributions to the maximum over the next 10 years or so, also create a good-sized emergency fund, and if a homeowner, consider lowering the payment or shortening the loan by refinancing with an increased down payment. And then finally, go on vacation. Yes, spend some small percentage on yourself and others to provide a once-in-a-lifetime gift that you'll always remember. You took this large sum and evaluated how to maximize it by putting yourself in a better long-term financial position and reducing your financial risk before spending it foolishly. But if you were in your late 30s and have a good amount of retirement savings, then after putting $8,000 toward additional savings or debt reduction, you take the remaining $2,000 and go on vacation (or some other spending on yourself), then that's ok - you addressed two needs: financial and mental health. If instead you were in your mid-50s when the winnings came, the answers would be different, but the process would be the same: identifying financial deficiencies to correct and reducing risk to maximize the good fortune before some discretionary spending.

While more savings are always better than less, one has to consider outstanding debt, future obligations (i.e., college educations, care for a parent, etc.), whenever confronted with an unexpected windfall. The 55-year-old may immediately think they can retire with the $1,000,000 on top of their current retirement savings. But when evaluating the numbers, it becomes obvious that stopping full-time work at 55 because you won $1,000,000 is a really bad financial decision. Besides the loss of income, there's the loss of employer retirement contributions, a much lower Social Security benefit, and a career interruption that can be impossible to correct if you need work income later. After evaluating the impact, however, it may be possible to retire a few years earlier than planned, but only after ensuring all the other things are taken care of.

Of course, with any large prize, there's the issue of taxes. Not just in the year received, but what you do with the remaining funds. Since there are limits on retirement contributions based on earned income, you would have to keep working to max out the contributions annually. Depending on age, you could consider other options such as whole life insurance or a deferred annuity, but all have to be evaluated (including commissions) to ensure the option is reasonable and cost-efficient before buying. As you think through this, you'll discover there are pretty big implications in future years with such a large windfall.

Finally, note that I didn't say lottery winnings. Playing the lottery on a regular basis is not financially smart, but you probably already know that.