Receiving a financial windfall can feel like a huge relief. It’s not often that people receive an unexpected or large amount of money all at once. It’s exciting to imagine all the things you can do with it, but you will want to be careful about how you spend and manage the funds so that you get the most financial benefit from it.
There are many ways you can spend a windfall. It can help you pay back debt, make a dream purchase, or add to your savings. But you should make sure you know all of the financial implications of receiving a financial windfall, including the tax consequences and what will happen to the money if you are in the midst of the insolvency process.
Let’s TalkWhat Is a Financial Windfall?
A financial windfall is any unexpected amount of money you receive. It could be an annual bonus from your job, an income tax refund, a government-funded grant, or proceeds from selling your personal work. It could also be an inheritance, lottery winnings, or gains from selling personal belongings.
The source of a financial windfall is essential when it comes to managing it because there may or may not be tax implications for the extra cash. It often makes sense to hold onto a substantial portion of a windfall until you have filed your taxes for the year in which you received it.
What Can You Do with a Financial Windfall?
Managing a financial windfall can make a big impact on the rest of your life. Major windfalls like inheritances or lottery winnings are rare events, and managing those funds well can improve your financial situation in the long run. The last thing a financial windfall should do is put you back into debt.
When you’re planning what to do with a windfall, it helps to look first at your current financial situation. One way to manage a financial windfall is to split it into three stages: debt, savings, and spending.
#1 Debt
If you have outstanding debts, one of the best financial decisions you can make is to use your windfall to pay them down. Carrying debt costs money in the form of interest charges, inflating the cost of what you initially borrowed. It often makes sense to pay off debt first before saving, except to put together an emergency fund. The sooner you clear your debts, the less you will pay in interest charges.
It makes sense to prioritize high-interest loans first, such as:
- Credit cards
- Payday loans
- Lines of credit
After that, consider student loans, car payments, and your mortgage, though be aware of penalties for paying early.
#2 Savings
Setting up or adding to your savings can help improve your long-term financial stability and success. Whether your goal is to save for your retirement, contribute to an RESP for your kids, or set up an emergency fund, a financial windfall can go a long way toward reaching that finish line.
If you are contributing to an RRSP or TFSA with a financial windfall, be mindful of your annual contribution limits, which are based on your income. Over contributing can lead to tax penalties.
#3 Spending
Being financially savvy with a windfall doesn’t mean you can’t enjoy it. It’s important that you plan the way you’re going to spend a financial windfall and that you don’t spend it all without considering the taxes, but with the right plan, you can make the most out of a windfall.
What Happens to a Financial Windfall in Bankruptcy?
As debt professionals in the GTA, we’re often asked what will happen if you file for bankruptcy only to win the lottery. While winning the lottery is not that likely, the same concerns can apply to an inheritance, a tax refund, or money withdrawn from an RRSP.
When you file for bankruptcy, you may have to sell certain assets with the funds distributed to your creditors. Bankruptcy can also involve making surplus income payments, where you pay 50% of any income above a certain limit determined by your family circumstance. Surplus income can be collected until your bankruptcy is discharged, usually up to 21 months after you file.
Surplus income and bankruptcy can make a financial windfall complicated. Unfortunately, windfalls such as lottery winnings are usually considered an asset, and the entire amount enters the bankruptcy estate, which means creditors can collect from it, and you will only receive leftover amounts. However, if the windfall is considered income, only 50% of the amount above your surplus income limits would be collected. Those limits are determined by the number of people in your household and rise with inflation each year.
What Happens to a Financial Windfall in a Consumer Proposal?
In a consumer proposal, you agree to a set monthly payment over a period of up to five years, and this payment is distributed to your creditors. It’s an effective way to erase your debts in Canada that works well for those who are earning a steady income but can’t keep up with their debt.
One of the advantages of a consumer proposal is that your agreement remains in place even if your income increases, whether you get a raise or a new job, or if you receive a financial windfall, whether it’s a work bonus or inheritance.
When you receive a financial windfall during a consumer proposal, you do not owe any of that money to your creditors. If you so choose, you can pay the balance owing on your consumer proposal. Paying it off sooner will mean your credit history will clear the consumer proposal sooner, making it easier for you to qualify for new credit and loans in the future.
How a Financial Windfall Can Create Tax Debt
The last thing you want is for extra cash to turn into debt down the road. Some financial windfalls count as taxable income in Canada, but because there are no taxes taken before you get it, you can wind up with a substantial bill by the time you file your taxes. When you receive a large sum of money, you are responsible for withholding the taxable portion and remitting those funds to the CRA (Canada Revenue Agency) by the deadline. Failure to do so can result in income tax debt.
The potential for getting into tax debt is why it’s so important to determine if the windfall is taxable and carefully plan how you’ll spend a financial windfall. However, if you’ve already spent the extra and you are already facing or worried about the consequences of owing money to the CRA, it may be time to explore your options for income tax debt help.
Taxable vs. Non-Taxable Windfalls
The difference between taxable and non-taxable windfalls in Canada depends on the source of the money. According to Canada’s Income Tax Act, income is taxable if it comes from:
- Employment earnings
- Business income
- Investment income from property or other assets
- Capital gains
It should also be noted that some government-provided benefits are also taxable. This includes Canada Emergency Response Benefits (CERB) and Canada Recovery Benefits (CRB). CRB tax payments are based on your annual income for the year in which you received the benefit. You can find out more about income limits and Canada recovery benefits to learn how much you may need to repay the CRA.
There are also a number of non-taxable sources of income, including:
- Lottery winnings
- Gifts and inheritances
- GST/HST credits
- Income tax refunds
- Canada Child Tax Benefits
- Child assistance payments
- Proceeds from a life insurance policy
- Income from a TFSA
- Most compensation for a personal injury
This doesn’t mean that these funds aren’t taxed at all. For example, inheritances are typically taxed as part of the deceased’s income at the time of death, so they are taxed before they reach the beneficiary.
It may not always be clear what the source of a financial windfall is and whether or not it is taxable. For example, if you work as an artist and sell a painting, the proceeds will count as taxable income. It can help to work with an accountant or tax expert when you receive a financial windfall.
How to Deal with CRA Debt
Not accounting for the taxes on a financial windfall can quickly turn sour. Many Canadians are used to having their taxes taken directly off their paycheque, and they may not realize what marginal tax rate they should be paying on windfall amounts. Canadians who receive a windfall should set this amount aside and be prepared to pay it to the CRA when they file their taxes.
If you find out that you owe taxes on a financial windfall you have already spent, you may find yourself in debt to the CRA. Depending on the amount, it can be a struggle to repay. Talk to a Licensed Insolvency Trustee about ways to deal with CRA debt. You can book a free consultation to talk to a debt professional about your financial situation and the best way to move forward.
Don’t let a financial windfall turn into a burden. If you can, plan how you’re going to manage it, find out the tax implications, and make sure you know what will happen to it if you are in the midst of a bankruptcy or consumer proposal.
