There are so many easy ways to overspend, but, according to financial psychologists, it’s even easier if you’re spending an unexpected windfall. Seven in 10 people who suddenly receive a large sum of money like an employee bonus, lottery winnings, or an inheritance will lose it all within just a few years.1
Why? “The way we label money has everything to do with how we spend it,” said psychologist and behavioral finance expert Daniel Crosby, Ph.D. In behavioral finance circles, there’s a theory known as mental accounting, which interprets the irrational ways in which people categorize and spend their funds. According to the notion, we’re more frugal with funds earmarked as important—like those saved for a child’s education, for example—and more extravagant with unexpectedly found money—like a substantially sized tax return. “Since an inheritance is typically not gained very effortfully, it is typically spent more loosely,” said Crosby.
The good news? A little financial know-how can go a long way toward investing an inheritance and preserving it for the long term. Here’s how.
More than half of households today are at risk of not having enough income to fund retirement.2 A moderate inheritance can improve an heir’s overall financial outlook. Not surprisingly, low- and middle-income earners have the greatest concerns regarding retirement income.
Even a modest inheritance can go a long way, if used properly. More than 14 and 18 percent of low- and middle-income earners, respectively, will become heir to amounts that average between $38,000 and $50,000. While these funds alone aren’t enough to fund a couple of golden decades, they can help bridge the gap between a worker’s current savings, and where he wants to be.
If properly managed, an inheritance—even if moderately sized—can bridge the gap between barely getting by and living a comfortable life. The simple act of changing the way the money is viewed can go a long way toward curtailing reckless spending and prompting a prudent savings strategy.
A $40,000 inheritance that’s viewed as an unexpected handout can easily be spent in a single fell swoop—on a new car, for instance. That same amount, if invested for 20 years at a 7 percent earnings rate, could grow to more than $150,000. That sum could go a long way toward funding an inheritance recipient’s retirement fund.
Lack of financial education isn’t the only reason inheritors can’t hold on to the payout. Many feel guilt over receiving money after the death of a loved one. Often, that guilt can cause an incentive for an inheritor to squander those funds. “I think one way to overcome this guilt is to spend it in ways consistent with the values of the deceased,” said Crosby. “For example, if my parents were to leave me money, I know they would be pleased at me using it to fund college accounts for my children.”
The key is to remember that your family member wanted you to have the money. Misuse of the money or spending it as quickly as possible won’t bring your loved ones back. Instead, “By spending it in a way that honors them, it extends their legacy,” said Crosby.
Of course, many heirs don’t know how to manage a large influx of funds and, for the financially unexperienced, it’s easy to make money mistakes. One effective way to create a solid plan for a new financial windfall is to seek the help of an expert.
A financial professional can help an inheritor assess spending decisions (like why a new car may not be the wisest decision) while at the same time, creating a long-term investment strategy. In fact, a recent paper3 reported that those who work with a financial professional are substantially more likely to be adequately prepared for managing an inheritance for retirement than those who do not.
The reason? “The primary good an advisor does is behavioral management,” said Crosby. Investors often get nervous by market swings and sometimes sell their holdings at the bottom of the market. In other words, they sell low and buy high, which is the complete opposite of the most basic of all investment tenets.
In other words, a financial professional won’t necessarily help an investor find stocks or bonds with a higher payout; instead, she can help her clients with a strategy that may reduce their risk of losing money by exiting the market when turbulence strikes.
Managing an inheritance is far from a simple task. To make the most of what your loved one left, it may be best to seek the advice of a professional who can put a plan in place to help you secure your financial future. After all, your late relative probably wanted you to live a long and happy life and, if allocated properly, those funds can be a conduit to do just that.
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Alaina Tweddale is a Philadelphia-based freelance writer. She formerly worked in the marketing departments of several financial companies including Lincoln Financial Group, Delaware Investments, and Cendant Mortgage. Her writing has appeared on MSN Money, BusinessInsider.com, FOXBusiness.com, The Motley Fool, SavingsAccounts.com, Wise Bread, and more.
This is a sponsored post by Prudential.
1. “Financial Psychology and Lifechanging Events: Financial Windfall,” National Endowment for Financial Education.
2. “How Do Inheritances Affect the National Retirement Risk Index,” Center for Retirement Research at Boston College.
3. “Does Financial Sophistication Matter in Retirement Preparedness?” Journal of Personal Finance.