If you’ve received a lump sum of money – perhaps a Christmas bonus or financial gift – you might be wondering what to do with it.

Splashing the cash is one option, but putting the money aside for your future self could prove a lot more rewarding in the long run. The key question is, where?

There are several options to choose from when investing a lump sum and it isn’t always easy to know which is best. To help you get started, we’ve summarised four of the main options below.

Emergency savings pot

First and foremost, it’s a good idea to check whether you have a sufficient emergency savings pot. That’s the amount of money you would need to cover unexpected bills, such as your boiler or car breaking down, or a period of unemployment.

For one-off expenses, one rule of thumb is to keep the greater of £2,000 or half a month’s expenses in a bank account. When it comes to an income shock, you’ll want more than just a few weeks’ savings set aside. We generally suggest holding 3-6 months’ worth of expenses in an accessible account. If you don’t have this already, consider using your lump sum to start or top up your emergency fund.

Diversified investment portfolio

For savings over and above your emergency fund, it’s worth considering investing in the stock market.

If you’re able to commit your money for at least five years and are willing to accept the risk that comes with investing, shares have historically offered higher returns than cash or bonds1 over the long term, albeit with greater volatility (or swings in prices). Although investments go down as well as up and you may get back less than you invested, history shows that patient investors tend to be rewarded for this extra risk.

One way to reduce the level of risk in your portfolio is to spread your money across different assets, such as shares and bonds. Different asset classes tend to perform differently in a range of economic conditions, which can help to soften the impact of losses in one part of your portfolio. You can diversify your investments further by investing in different sectors and regions.

Ensuring you have a balanced portfolio isn’t always easy to do on your own. That’s why our all-in-one multi-asset funds, such as our LifeStrategy funds, and our ISAs and pensions which we manage for you, are already diversified across global shares and bonds.

Tax-efficient ISA

To really make the most of your lump sum, you need to make sure you’re not paying more tax than necessary. An easy way to do this is to invest in an individual savings account (ISA). This is a tax-efficient ‘wrapper’ that lets your money grow free from the income tax you might pay on the dividends or interest you receive, as well as the capital gains tax (CGT) that could be applied on any profits that you make. Under current rules, you can invest up to £20,000 in ISAs each tax year.

Using your ISA allowance could be even more important this year because the tax-free CGT and dividend allowances are being cut further. For investments outside an ISA, you can make tax-free capital gains of up to £6,000 in the 2023-24 tax year, but this allowance will be halved to £3,000 in 2024-25. Similarly, the dividend allowance – the amount of dividend income you can earn before being taxed – will be halved from £1,000 to £500.

When you’re choosing an ISA provider, remember to also check how much they are charging to invest your money. Costs eat into your investment returns, so the lower the charges, the greater your chances of investment success.

Personal pension

If you don’t need your lump sum any time soon, investing it in a pension could give your retirement savings a much-needed boost.

Your retirement might be decades away, but it’s never too early to start investing. You could spend two or even three decades in retirement, so the more you can contribute to your pension now, the better. Investing early on will let you harness the full power of compound returns – when you get returns on your returns as well as on your initial capital.

As the chart below shows, compounding can be particularly powerful over long periods. In our hypothetical example, a lump sum investment of £10,000 grows to £16,289 after 10 years, assuming annual returns of 5%. Over 20 years, the investment increases to £26,533, and after 40 years its value balloons to £70,400.

It pays to start early

Notes: This hypothetical scenario is for illustrative purposes only and doesn’t represent a particular investment or its expected returns. It assumes annual returns of 5%. Balances reflect the value at the end of each period. The chart doesn’t account for taxes and management or platform fees.

When you make a personal pension contribution, you’ll also get an additional 20% in pension tax relief from the government. For every £80 you contribute to your pension, you’ll get a top-up of £20. If you’re a higher-rate or additional-rate taxpayer, you can claim back an additional £20 or £25, respectively, via your self-assessment tax return. This can help to supercharge how much money you have at retirement, and really make the most of that unexpected lump sum.

Bonds are a type of loan issued by governments or companies, which typically pay a fixed amount of interest and return the capital at the end of the term.

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Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

The eligibility to invest in either ISA or Junior ISA depends on individual circumstances and all tax rules may change in future.

Any tax reliefs referred to in this document are those available under current legislation, which may change, and their availability and value will depend on your individual circumstances. If you have questions relating to your specific tax situation, please contact your tax adviser.

For further information on risks please see the “Risk Factors” section of the prospectus.

Important information

Vanguard Asset Management Limited only gives information on products and services and does not give investment advice based on individual circumstances. If you have any questions related to your investment decision or the suitability or appropriateness for you of the product[s] described, please contact your financial adviser.

For further information on the fund's investment policies and risks, please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions. The KIID for this fund is available, alongside the prospectus.

This is designed for use by, and is directed only at persons resident in the UK.

The information contained herein is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The information is general in nature and does not constitute legal, tax, or investment advice. Potential investors are urged to consult their professional advisers on the implications of making an investment in, holding or disposing of shares and /or units of, and the receipt of distribution from any investment.

The Authorised Corporate Director for Vanguard LifeStrategy Funds ICVC is Vanguard Investments UK, Limited. Vanguard Asset Management, Limited is a distributor of Vanguard LifeStrategy Funds ICVC.

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