Miser Inheritance – When Contribution Maximums Matter 

Making the most of gainful surprises

When we think of financial surprises it’s usually in the form of an unplanned tax debt, a sudden bill, or some irksome expense that comes out of the blue.

Every now and then though, luck (or, more likely circumstance) decides to give us a break and sends some handy extra cash our way. Sometimes it’s a bittersweet inheritance, sometimes it’s from an upheaval, such as a severance package, and for the rare few, it simply comes from holding that one, lucky lottery ticket. But, no matter how the windfall came about, once its reality starts to sink in, the mind naturally leans towards what to do with it.

A smart strategy may be to invest it for a more comfortable retirement. But if you put it all in a term deposit or add to an investment portfolio, the earnings will generally incur tax. A more effective option, may be to contribute to your 401(k) workplace plan. But beware, like other countries, such as Australia, there are actually limits to how much you can plough in each year. In the US, these caps are called 401(k) Employee Annual Contribution Limits.

Windfalls and 401(k) plans

There are two types of 401(k) options. The standard ‘Traditional’ version gives you an up-front tax break, while the ‘Roth 401(k)’ gives you a tax-free income in retirement (since you’ve already paid tax on the money you’ve contributed).

Either way though, the annual limits are the same.

Currently (in 2023) the contribution limits for individuals are:

Under 50yo: $22,500 total per year

50yo or older: $30,000 total per year

The limit for over-50s is higher thanks to the $7,500 catch-up contribution that’s available once you hit 50.

Provided you opened your 401(k) at least five years beforehand, using a windfall to boost your retirement gives you the benefit of additional tax-free income stream when you reach 59 years and six months.

Even if retirement for you is years away, investing surplus cash in your 401(k) up to the maximums can still be a sound strategy, as long as your current miserly approach to spending is covering your needs right now.

Windfalls, investments and tax

One side-effect of a sudden rush of cash to the hip pocket, can be a sudden rush of blood to the head – figuratively speaking at least.

Even smart minds may briefly picture a shiny Mercedes parked outside the new beach house, but such visions should be quickly shrouded by more sensible and astute ideas.

As previously mentioned, interest accrued on term deposits and earnings on investments generally attract some form of tax, and while the tax shouldn’t exceed your returns, they can take a fair bite out of them. That’s why, it’s always shrewd to seek professional advice if your windfall is substantial – especially if you want to maximise the tax advantages.

Of course, some bonanzas are taxed at the outset.

Lottery wins across the US are taxed at federal level as they’re considered to be part of your income. And then depending on where you live, even more may be collected by the state coffers. The same goes for severance packages.

On the flip-side, inheritances are not taxed, except in a handful of states1 (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania), and even then, there are conditions based on the amount you inherit, and how you’re related to your benefactor.

This means that, outside of contributing to a 401(k), the source of your financial bonus may influence where and how you invest.

Ultimately though, if you find yourself the recipient of an unexpected windfall, the best advice is professional advice.

Let the emotions settle before making any big decisions, make an appointment with a financial planner, and definitely do not duck into a luxury auto showroom on the way.

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