Best ways to spend a $25,000 windfall

With many debts, which ones get paid first?

To Her Credit columnist Sally Herigstad
Sally Herigstad is a certified public accountant and the author of "Help! I Can't Pay My Bills: Surviving a Financial Crisis" (St. Martin's Press, 2006). She writes "To Her Credit," a weekly reader Q&A column about issues involving women, credit and debt, for, and also wrote for MSN Money, and, and has guested on Martha Stewart Radio and other programs.

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Question for the expert

Dear To Her Credit,
I recently inherited $25,000, and I would like to know the best way to use this money. I owe $13,000 in back taxes, and I also owe $15,000 in credit cards and loans, which I am currently paying via a consolidated credit nonprofit organization. I have two car payments plus my mortgage. Any suggestions? -- Lisa

Answer for the expert

Dear Lisa,
The easiest answer to your question would be to pay off the $13,000 in back taxes and $12,000 of your credit card debt. But then your money is gone, and there's nothing to stop your debts from creeping back up again. Next time your car needs transmission work or you need dental work, you'll have little choice but to put those charges on your credit cards. Many people find, to their dismay, that after they pay off debts with a windfall, they are soon right back where they started.

The best way to keep that from happening is to take part of your inheritance and start an emergency fund. Put it in a savings account, money market or other place where it's safe and easily accessible when you need it. (But not too easily. Some people find their emergency fund should not be connected electronically to their checking account or accessible by ATM card, for obvious reasons!) Next time you have an emergency, instead of going further into debt, you'll be able to pay cash. By then, you'll be so used to having that fund that you'd feel almost naked without it, so you'll immediately work on putting money back in.

The size of your emergency fund depends on your living expenses and comfort level. Let's assume you should have $5,000 in your fund at all times. Learn the mindset that if you don't have $5,000 in the bank, you're living on the edge. Work and save until you build it up again.

Use the rest of your money to pay off debt. Pay the debt with the highest interest rate first to reduce your monthly interest expense and maximize the amount of future monthly payments that will go toward paying off your debt.

Your credit cards and loans are probably at a high interest rate. Pay them off. They're gone -- doesn't that feel better?

Your car payments are next. Making two car payments has to be difficult. The difference between a comfortable lifestyle and one spent just barely making it from one paycheck to the next is often whether a person has car payments. Can you sell one car? I'd sell the one with the highest balance. If possible, pay off the other one. Set up an automatic savings plan for your next car using the amount you're used to making in car payments, and promise yourself you'll never buy a car on time again.

That leaves you with nonmortgage debt of $13,000 in back taxes. Many people would pay off taxes first, just because nothing scares them more than dealing with the IRS. You should certainly keep up with taxes and avoid ever getting behind again. However, you already have this debt, and currently the IRS interest rates on late taxes are quite low. They may even be lower than your mortgage rate. Assuming you are on a payment plan with the IRS, you should pay off what you can with any remaining inheritance and then pay off the rest as quickly as possible. (As always, discuss tax issues with your accountant.)

To recap, here's how I recommend you use your inheritance:

Emergency fund: $5,000
Credit card debt: $15,000
Car loan: up to $5,000
Back taxes: Any remaining

You might feel like your inheritance came and went, and you have nothing to show for it. However, $25,000 can change your life! Instead of scrambling to catch up with your debts, you can now work to pay off the few remaining bills and start saving and investing for the future. Your inheritance has given you something of great value -- a fresh start. Use it wisely.

See related: Inheritance strategy: pay off mortgage or credit cards?, Best use for inheritance: pay debt or create savings?, Emergency fund, retirement, come before credit card debt

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Updated: 01-19-2019