Earlier this week my friend Paul told me he had bought tickets for the Lotto Max lottery, which had a $70-million prize available for Tuesday’s draw. “Tim, if I win, all my neighbours are going to be rich,” he said. “That’s nice of you to give money away like that,” I said. “No, they’ll be rich because I’m going to move to a wealthy neighbourhood,” he replied. So much for altruism.
As it turns out, someone who purchased a ticket in Brampton, Ont., did win the $70-million prize in Tuesday’s draw, and 17 others won prizes from $100,000 to $1-million. In Canada, those prizes are tax-free (unlike south of the border; lottery winnings is one area where our tax law is more favourable than that of the United States).
This raises the question: What should you do with a windfall? And to be sure, not all windfalls are lottery winnings. Perhaps you’ve inherited money, received a gift, or have come into some cash by a tax refund, business sale or some other means. What will you do with the cash? Here are some thoughts to consider.
Spend the money. Spending some of that windfall could be a lot of fun. In addition to buying a new home, my friend Paul told me he was going to fly a fighter jet, race water buffalo in Indonesia and fly in a hot air balloon in Turkey – all life experiences that you can pay for. Spending part of your windfall is probably okay, provided your retirement savings are under control and you’ve got little or no “bad debt” (which I’ll talk about next). As for retirement savings, your windfall may be enough to look after that – but not likely. Even the six people who won $1-million this week in the Lotto Max lottery may be surprised to learn that a million dollars isn’t going to be enough for most people to retire. I started a conversation about retirement planning last week and will continue next time.
Pay down debt. There’s good debt and bad debt. Good debt arises where you’ve borrowed money to buy an asset that will grow in value, and it’s even better when you can deduct your interest costs. Your home mortgage is generally a good type of debt despite not being able to deduct your mortgage interest (unless you run a business – even part-time – from your home, in which case part of your mortgage interest can be deductible). Bad debt usually has three characteristics: The interest rate is high (think credit cards), the debt is for personal consumption (as opposed to buying a growing asset) and the interest is not deductible. You should use a windfall to pay down your bad debt. Paying down this debt provides you with a guaranteed rate of return that is equal to your interest costs. For example, paying down a credit card that charges 19-per-cent interest will allow you to achieve a 19-per-cent rate of return. Not many investments will provide the same.
Invest the money. Although paying down debt – particularly bad debt – is always a good idea, setting aside some of that windfall for retirement will be important if you’re behind in your retirement savings. You might even consider paying down some of your debt, then reborrowing to invest. Your total debt may not decrease in this case, but you’ll be able to deduct your interest costs if you’re investing outside of your registered plans since you’ll be borrowing to earn income. Using your windfall to maximize your registered retirement savings plan (RRSP) and tax-free savings account (TFSA) contributions generally makes good sense. You might also consider contributing to a registered education savings plan (RESP) for a student in your life because this can come with grants from the government to boot.
Give it away. Let’s not forget about the option of making a donation to help others. The fact is, a portion of your money is earmarked to help society, whether you like it or not. If you don’t give voluntarily, you’ll give involuntarily through our tax system. Most people find it more meaningful to “self-direct” this social capital by making donations. Donations will not only provide you with personal tax savings through a donation tax credit, but you’ll be helping causes you believe in. For every dollar you give away, the government will participate in that donation by providing tax savings of about 40 to 50 cents (the actual savings vary by province and income level).
If you’ve come into a windfall of significance, pause before doing anything. Then, don’t assume the money will last as long as you hope. Finally, seek the advice of reputable investment specialists and tax advisers.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at tim@ourfamilyoffice.ca.
Tim Cestnick