What should I do with a lump sum?

If you're about to get a windfall, such as a modest inheritance or a payout from an insurance policy, how should you consider using your cash? 

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

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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. 

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

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

Informative, in-depth and in the know: get the latest news, interviews and reviews with Saga Magazine.

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.

Paul Lewis on the 6 things to do before you're 60.

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. 

Could you be sitting on a fortune?

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.

Informative, in-depth and in the know: get the latest money news with Saga Magazine. 

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 relatively new (it's been around since 2005) 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.

Find out more about tax and gifting money to children.

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.

Use our free Equity Release calculator.