Anticipating an Insurance Payout? What You Should Do First (And What Not To Do)

Years ago, the remnant of a hurricane came through Maryland and dropped half a tree on my house.

It pushed a roof joist through my bedroom ceiling right over where the three-year-old daughter of my then-girlfriend, now wife, slept.

Miraculously, it stopped several feet above her.

She slept right through the whole thing.

After hitting the roof, the tree fell onto my large deck, causing significant damage.

Finally, it bumped against the garage, breaking a window.

That’s where it stopped.

Dealing with the Insurance Company

It took a while for an adjuster to show up since there were hundreds, if not thousands, or tens of thousands of claims statewide.

He looked inside the house and out, taking pictures and notes.

Then he left.

A week or two later, I got a check for about $10k.

I could have simply accepted it as the likely cost of repairs. Thankfully, I had a friend in the decking business who came over and noted that one of the long stringers supporting the deck had been broken. Replacing that would require taking the planks off nearly the entire deck.

He gave me a written estimate for that repair, which I sent to the insurer.

They promptly sent me another check for about $10k more.

Note to self — don’t automatically accept an insurance payout as the final word.

What I Did with the Insurance Proceeds

First, I hired contractors to repair all the damage.

My friend did the deck work at a discount, which ended up saving me several thousand dollars.

Some of that savings went to help pay off a small credit card balance, while the rest went into my emergency fund.

That was a fairly small insurance payout.

But what would you do with a large one, say a million-dollar life insurance payout?

9 Things Experts Say You Should Do with a Significant Insurance Payout

If the payout was due to damage to your home (as was mine) or car, you should use the insurance proceeds to repair or replace what was damaged, assuming you still need it.

After that, experts recommend pausing for a while to avoid making major mistakes.

As the saying goes, “Decide in haste, repent at leisure.”

Terry Parham Jr, Wealth Advisor & Owner, Innovative Wealth Building, says, “Receiving a substantial life insurance payout requires a cautious approach. Often, recipients rush into purchasing high-value items like new vehicles or properties or quickly pay off debts such as mortgages and student loans. Although these actions are not negative in and of themselves, making them hastily without considering their long-term implications can be risky. Implementing a ‘cooling-off’ period of, say, 30 days before making any significant purchases can help you avoid costly financial mistakes.”

Omar A. Morillo, Founder of Imperio Wealth Advisors agrees, “I caution against drastic lifestyle changes or large purchases soon after receiving the payout.”

While you’re on pause, put your money to work for you by placing it in a high-yield savings account, money market, or short-term CD. 

If the sum is larger than the Federal Deposit Insurance Corporation (FDIC) $250k coverage, you can split it among different accounts. For example:

• Different account types: savings, checking, money market, etc.
• Different ownerships: yours, your spouse’s, joint accounts
• Different financial institutions

If you use the three account types, three ownerships, and say two banks, that’s 18 times the coverage (3×3×2), or $4.5 million in free FDIC coverage.

Next, consult with a financial advisor.

This may seem a little self-serving for advisors to recommend, but if you’re not used to dealing with large amounts of money, wouldn’t you benefit from expert advice?

Parnham Jr. says, “Engaging a financial professional is highly advisable. Their expertise can guide you in making decisions that are best suited to your circumstances and financial goals, potentially making it the most beneficial investment you could make.”

Third, with the aid of your advisor, update (or create) your financial plan.

Morillo says, “Every situation is unique, but I typically recommend that clients who receive a significant insurance payout first revise their financial plans. It’s crucial to realign your budget and goals to account for this new economic reality. By taking these steps, you ensure the windfall serves your financial objectives now and in the future.”

Parnham Jr. explains, “Life insurance proceeds, generally tax-free, present unique opportunities for impactful financial planning. Start with a comprehensive financial assessment to fully understand your new financial situation and objectives. This insight allows you to develop strategies that align with your goals and provide optimal outcomes.

“Updating your financial plan is crucial before proceeding with any significant financial decisions. Conduct a detailed review of your current assets and liabilities, reassess your goals, and evaluate your risk tolerance to ensure your financial strategy remains suitable.”

Carman Kubanda, Financial Planner at Innovative Wealth Building adds, “I usually recommend addressing needs first. Is there an income need if they are retired? Is there debt or some other financial goal? Getting an objective third party (like a financial planner) to provide guidance specific to their situation can be one of the best things someone could do.”

Fourth, update (or create) an estate plan, and buy (or increase) life insurance coverage. Especially if the payout is very large, an estate plan and a life insurance policy can help your loved ones when you pass away. Parnham says, “After a major payout, revisiting life insurance, beneficiaries, and estate planning becomes more relevant.” Morillo agrees, “Revisiting your current estate plan is a good idea.”

Fifth, use a small portion of the money for discretionary spending.

Morillo says, “Wanting to spend some money is understandable, so I advise setting aside a small portion, about 5-10% of the payout, for immediate or discretionary expenses, which allows for some immediate enjoyment or covering pressing needs without compromising financial stability.”

Michael Rosenberg, Managing Director and Founder of Diversified Investment Strategies, LLC feels similarly, “I usually tell people it is ok to purchase something like a piece of jewelry to have as a keepsake and remembrance of the loved one.”

Sixth, pay off high-interest debt, if any. This should be part of your new or updated plan.

Morillo is emphatic on this point, “Most importantly, prioritizing high-interest debts for repayment can provide relief and improve financial health.” 

Rosenberg agrees, “Paying off high-interest debt is a good next step.”

Next up, at number seven, is (setting up or) funneling some of the money into an emergency fund. This can also serve as a temporary place for money you’ll need to pay any taxes (though as Rosenberg clarifies, insurance payouts should not be taxable, “It is important to know that life insurance proceeds are not subject to tax, so these funds would be tax-free”).

On this point, Morillo says, “Planning for taxes and setting up an emergency fund are top priorities.”

The eighth recommendation is to set aside money for long-term investments. This could be for retirement, kids’ education, or any other significant long-term goal.

Morillo advises, “Consider investments for long-term growth. When thinking about investing, it’s vital to diversify to mitigate risks and maximize returns according to your risk tolerance and investment timeline.”

Daniel Masuda Lehrman, Owner and Financial Planner, Masuda Lehrman Wealth agrees, “If you received a substantial life insurance benefit, after ensuring your emergency fund is fully funded and any high-interest debt is paid off, set aside funds for retirement, education, and other important long-term goals in your financial plan.”

Parnham expands, “Consider setting financial priorities such as maximizing contributions to tax-advantaged accounts like a 401(k) or SEP IRA, saving for educational expenses, creating a taxable investment account, etc.”

The ninth and final recommendation is to consider a Roth conversion. Since this would increase your taxable income, and thus your taxes, you could use a portion of your insurance payout to cover those extra taxes. As Parnham suggests, “Explore possibilities like rolling over some proceeds into retirement accounts such as IRAs or converting into Roth IRAs.”

3 Things Experts Recommend Avoiding

Now that we’ve covered the 9 things to do, here are 3 things to avoid doing.

First, and perhaps not surprisingly, keep it quiet – don’t announce your good fortune on social media. Morillo explains, “Keeping the windfall private minimizes risks like fraud or unwanted solicitations.”

Second, as many a lottery winner learned too late, don’t inflate your lifestyle to unsustainable levels. Morillo again, “I caution against drastic lifestyle changes or large purchases soon after receiving the payout.”

Finally, don’t rush to pay off your mortgage, even if you face pressure to do so.

Rosenberg explains why, “I would not use a large payout to pay down your mortgage since most mortgage interest is still tax deductible. So, as long as your after-tax mortgage interest rate is lower than what you can earn long-term from investing your money, I would suggest investing the funds according to your risk tolerance and time horizon. 

“Historically, over 10 years, you should be able to receive a 7% return on money, so if your mortgage interest (after any tax deduction it generates) is below 7% it’s financially better not to pay it off.”

What Should You Do With An Insurance Payout?

Receiving a sudden large insurance payout can be a huge financial boon. However, the degree to which you deploy the money thoughtfully will affect how well things turn out for you.

Ross Dugas, PhD, Founder and Financial Advisor at Scientific Financial sums things up, “If the payout isn’t earmarked to replace something lost (car, house, etc.), you can use it to improve your financial picture. The best use of funds will depend on the individual but can include saving, spending, paying off debt, or investing. Paying off high-interest debt (higher than historical investing returns) is often a good decision. 

“A sudden cash windfall can also provide the opportunity to build up an emergency fund, increase 401(k) contributions, or contribute to a Roth IRA or Roth 401(k) to take advantage of the higher limits using after-tax contributions. Every situation is unique. What’s important is that you make thoughtful choices that are most impactful for your situation, and even spending could be a part of that plan.”

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.