Most of us have fantasized about gaining unexpected wealth, and all the ways it would change our lives for the better.

Unfortunately, managing an actual financial windfall — whether it’s a raise or bonus at work, a large inheritance, or a life-changing lottery jackpot — can be incredibly tricky.

You see, when most people unexpectedly come into money, they feel an overwhelming urge to spend it. And they’ll come up with all sorts of rationalizations to justify doing so, even when they know it could be put to better use elsewhere.

Believe me, I know… For much of my life, that’s exactly what I did.

Whenever I got a raise or a bonus — and as a dedicated and hard-working employee, I got my fair share — I would immediately increase my spending, rather than use the funds to pay down my ever-growing debt obligations.

But that all changed about 10 years ago…

At the time, my life looked great… on paper. I had a wonderful young family and a rewarding career. I was making an enviable amount of money, year after year. By almost any measure, I was a “success.”

Yet I was lying awake most nights wondering how I was going to pay the bills. And nothing in my life has ever eaten away at me as much as the fear of letting my family down.

Years of living beyond our means had left us with five substantial pieces of debt — one mortgage, one home equity loan, one auto loan, a large credit card balance, and a large graduate student loan. (We had previously had six, but to our credit we had just paid off the loan on my wife’s SUV.)

I finally reached financial “rock bottom” when I had to take $2,000 from my little girl’s savings account — which was all the money we had saved for her college fund at that point — just to pay our mortgage one month.

My wife and I resolved then and there to get out of debt — somehow, some way — and never put our family in that situation again.

And while we didn’t know exactly how we were going to do it, we decided to start by focusing on the positive… As I mentioned, despite our struggles, we had just paid off my wife’s car in full. It was a small “win,” but it was something.

Unfortunately, that positive feeling didn’t last long…

Just two weeks later, my wife was involved a car accident. And while she was fortunately not seriously injured, her newly-paid-off car was completely totaled.

It was like a punch to the gut.

Just like that, our small win was wiped out. The best we could hope for was to get enough money from the insurance company to get a serviceable replacement vehicle without having to take on too much more debt.

Or so I thought…

It turns out the insurance company sent us a check for $17,000… far more than her car was worth by even the rosiest estimate.

Had this good fortune happened even a few weeks earlier, we probably would’ve spent the entire check on an even nicer new car. But with our new mindset, we looked at that money as a lifeline to a better future. And after some careful consideration, we got to work.

The first thing I did was pay back the $2,000 I had borrowed from my daughter’s college fund. My wife started driving my SUV, and I replaced it with a practical and fuel-efficient Honda Accord. And then we used the rest of the money to begin paying down our highest-interest-rate debt.

I can honestly say that was the smartest thing I’ve ever done… It had an incredible “domino effect” that truly changed our lives for the better.

Now, I can’t magically grant you this same mindset. But I can share some simple steps I learned along the way to help you manage a potential financial windfall more effectively. 

Step 1: Take a Breath

When we come into money, our natural reaction is to do something with it immediately. And as I mentioned earlier, that “something” is typically spending it.

So, the first step I recommend is simply to stop and take some time before you do anything.

Give yourself a few weeks or even a few months to review your current financial situation and clarify your priorities (which we’ll cover in several of the next steps below.)

If your windfall is the result of an emotional event — such as losing a loved one or winning a lottery — this will also give you time to process your emotions before acting.

In the meantime, I would suggest holding the funds in the safest, most liquid form of cash possible, such as an FDIC-insured bank account or short-term U.S. Treasury bills.

There is one potential exception to this step. If you have any high-interest-rate debt that could be paid off with a portion of your windfall (say, 50% or less), you could consider doing so immediately (see Step 5 below). 

Step 2: Know Your Numbers

Take a simple inventory of your personal “balance sheet,” including all assets (real estate, investments, savings, etc.) and liabilities (mortgages, auto or student loans, credit card balances, etc.).

You’ll also want to figure out the tax bill (if any) you’ll owe on your windfall, so you know exactly how much of that money is available to you. 

Step 3: Don’t Be Afraid to Ask for Help

If you’re fortunate enough to be dealing with a significant sum of money — or you otherwise need help figuring out your numbers in the previous step — you may want to work with a professional.

This could include a certified public accountant (“CPA”) or tax adviser, an estate planning attorney, or a financial planner or adviser. When choosing the latter, you’ll want to be sure to work with a “fiduciary,” who is legally required to act in your best interest. 

Step 4: Build Your “Rainy Day” Fund

Now that you’ve gotten clarity on your current financial situation, my first recommendation is to start a “rainy day” fund if you don’t already have one.

At a minimum, I would recommend setting aside at least a few months’ worth of expenses before doing anything else. That includes even paying down debt in most cases.

The reason is simple… If you don’t have a minimum amount of savings, you’re effectively living “paycheck to paycheck.” Any kind of unforeseen expense — a medical emergency, car trouble, a major home repair, etc. — can instantly put you deep (or deeper) into debt and derail your financial future.

Having even a few months of extra savings can help prevent this from happening.

Ultimately, I would urge you to work to build up at least one full year’s worth of minimum expenses. This is the amount you would need to cover the “essentials” — to pay your mortgage or rent, pay all your necessary bills, and put food on the table — if you had no income for 12 months.

That probably sounds excessive to most folks in today’s world, but I can tell you it gives you tremendous peace of mind you can’t find anywhere else. I sleep soundly at night knowing that I have the means to handle just about any financial emergency without falling back into debt or jeopardizing my family’s financial future. 

Step 5: Pay Off “Bad” Debt

Once you have at least a few months of expenses in your rainy-day fund, I would recommend devoting your windfall to paying down “bad” debt. This includes any high-interest and/or variable-rate debt you may owe, including credit cards, personal loans, and auto loans.

The exceptions generally include low-interest, fixed-rate debt like mortgages, business loans, and potentially student loans.

Paying off high-interest debt isn’t exciting, but it’s the fastest and most powerful way to improve your financial situation.

For example, paying off a credit card that charges 20% interest is like earning an instant 20% return on your money. If you can find that kind of guaranteed, risk-free return anywhere else in today’s investment markets, I want to hear about it!

If you’re able to pay down your bad debt completely, I would then recommend using any additional funds to finish building your rainy-day fund up to one full year of minimum expenses.

Only after I’ve completed both Steps 4 and 5 would I then move on to the others below. I believe they’re just that important. 

Step 6: Invest for Retirement

If you still have funds remaining after building your savings and paying off debt, I would next recommend fortifying your retirement accounts.

This includes maxing out your current contributions to your 401(k) plan or individual retirement account (“IRA”), setting aside funds to maximize future contributions, and potentially making “catch up” contributions if you’re eligible to do so.

These accounts aren’t the place to take big risks. But if you’re behind where you need to be with your retirement investments, there are some relatively safe ways to “juice” the returns in your IRA or self-directed 401(k).

The simplest is selling covered call options on high-quality stocks you already own. But you could also consider a more innovative strategy like the one TradeSmith Senior Analyst Mike Burnick recently introduced. This “alt shares” strategy can deliver up to 10 times the return of ordinary stocks while risking as little as one-tenth the money. These six steps cover what I consider to be the “essentials.”

They’re the financial equivalent of that familiar advice travelers hear at the beginning of every commercial flight: “In the event of an emergency, secure your oxygen mask over your own mouth and nose before assisting others.”

It makes no sense to try to invest if you haven’t taken care of your basic financial health. But once you have those bases covered, you can afford to be more flexible.

Here are several other ways you could allocate your windfall (in no particular order). 

• Diversify your investment portfolio. There are many potentially lucrative strategies you could consider with additional funds, including long-term dividend investing, trading options for income (my favorite), investing in cash-flow-producing real estate or productive farmland, investing in private markets or start-ups, etc.
• Invest in the future. If you have children or grandchildren, you could set up and contribute to tax-deferred college saving plans. You could also consider funding an inheritance for them, so they’ll eventually receive a windfall of their own.
• Make a down payment on a new home. If you’re currently renting, you could set aside some money for a future home purchase.
• Pay down a high-interest-rate mortgage. Hopefully, you were able to lock in a low rate on your mortgage over the past few years. But if you purchased a home recently or are otherwise paying a higher rate than you’d like, it could make sense to pay down your mortgage more quickly.
• Take care of any necessary home or auto repairs you may have been putting off. Replacing an old roof or transmission before it fails can save you a lot of trouble down the road.
• Start a side business.
• Be charitable. A windfall can give you the opportunity to support your community or help those in need.
• Treat yourself (within reason). You could set aside a small portion of a windfall (say no more than 5% to 10%) to splurge on something fun. This can help you stay disciplined with the rest of your money.
  
  I’d recommend focusing on experiences (like a vacation or trip) rather than material items (like a new car or TV), as they tend to produce more lasting enjoyment. Just be sure to not to go overboard and create new spending habits you can’t afford over the long term.

These ideas aren’t revolutionary, but they were a huge help in managing my own windfall and getting my financial future back on track. I hope you’ll keep them in mind if you find yourself in a similar position, especially if you’re currently struggling financially like I was.

As always, if you have any questions or comments on today’s editorial — or any previous Money Talks topics — I’d love to hear from you at [email protected]. I can’t respond to every email, but I promise to read them all.