What should I do with a lump sum?

Chris Torney / 01 February 2016

Have you come into a bit of money? Read our tips to ensure your lump sum is spent or invested wisely.

Between January and May this year, thousands of over-65s had the chance to access the money that had been tied up for 12 months in the government’s “pensioner bonds”. 

The bonds were put on sale in the first half of 2015 by the state-backed National Savings & Investments bank, and savers were allowed to deposit up to £10,000 each at an attractive rate of interest.

So if you are a bondholder who has got your £10,000 back, or if you are about to get another type of windfall such as a modest inheritance or a payout from an insurance policy, how should you consider using your cash? 

We have put together a step-by-step guide to making the right decision.

1. Work out your financial priorities

The first step is to assess your financial situation and identify how your windfall could be of the greatest benefit. For example, if you have any debts, it may well be worth paying them off, if possible.

The crucial factor here will be the level of interest you are paying on those debts: the higher the interest, the better off you’ll be by clearing the debt as quickly as possible. 

Interest rates on credit cards and store cards can be especially high, whereas mortgage rates are in general pretty low at the moment.

Seven signs you need to get on top of your finances.

2. Look at your income

If you want your windfall to boost the income you get from your personal and state pension plus any other savings or investments you have, you have a number of options, from putting the money in a savings account to investing it in the stock market.

But bear in mind that, with interest rates relatively low at the moment, the returns that could be generated via a savings account by a £10,000 pot would be just a few hundred pounds a year – which is unlikely to dramatically enhance your lifestyle.

If you are happy with the level of income you already have, using a windfall for one-off spending, such as home improvements or even a holiday would be a perfectly reasonable thing to do.

Read Paul Lewis' guide to boosting your state pension.

3. Low-risk options

However, many people might rather choose put their money aside for a rainy day. So where should it go? 

This depends largely on your attitude to risk. If you want to keep your capital absolutely safe, you could go for a savings account or bond. You will get more interest from longer-term fixed-rate bonds – so by agreeing to lock your money up for, say, five years, you might be able to earn interest of around 3% a year. 

Premium Bonds are another low-risk option: on average, returns are unlikely to be quite as high as with best-buy savings accounts, but there is always the chance of winning a monthly prize.

Could you be sitting on a fortune?

4. Greater returns from higher risk

In order to get better returns, you will have to take on some extra risk – and this means you could lose some of your original capital. For example, putting money into shares via an investment fund could potentially be much more rewarding than a deposit account.

Funds tend to be less risky than buying individual shares because they are diversified and hold shares in a large number of companies – the chances of them all performing badly at the same time are lower. At the same time, some funds – for example, those which hold only large, blue-chip shares – are less risky than others.

Another alternative is a new financial product called peer-to-peer lending

People with money to save use online platforms, such as Zopa and Ratesetter, to lend cash to other individuals. This is then repaid every month with interest. 

Again, there is a chance money could be lost to bad debts or defaults, but the loans are spread among a number of borrowers to minimise risk. On peer-to-peer loans, annual returns can work out at around 5%.

Read Annie Shaw's guide to common investment mistakes. 

5. Consider making gifts

One final option is to give the money away. This might not seem an obvious thing to do, but it can help to reduce any future inheritance tax bill your family faces. Any gifts you make will be free of inheritance tax if you live for seven years after making them.

But there is also a £3,000-a-year gift allowance, which means you can give away up to £3,000 in any financial year with no further tax implications: the seven-year rule doesn’t apply here.

The £3,000 allowance can be carried over to the next year (but not to subsequent years) so you can gift £6,000 this year provided you didn’t give any money away in the last tax year.

Find out more about tax and gifting money to children.

The opinions expressed are those of the author and are not held by Saga unless specifically stated.

The material is for general information only and does not constitute investment, tax, legal, medical or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.