If you’ve received a life-changing sum of money through a legal settlement, herein lies an opportunity to get ahead financially. Once you’ve covered your legal-related costs, you have so many investment opportunities at your disposal to set you up for future success. In this guide, you’ll learn how to invest your settlement proceeds while considering your financial goals, tax obligations, and risks.
Tax Implications for Settlement Money
Whether you’ve received mesothelioma compensation for yourself or a loved one, a personal injury settlement, punitive damages, or another form of compensation, you must consider the tax implications of that money before proceeding with any form of investment. Whether and how compensation is taxed depends on the type.
The IRS deems that all income is taxable from whatever source derived, unless exempted by another section of the code. IRC Section 104 offers an exclusion from taxable income regarding settlements, awards, and lawsuits, but the facts surrounding each payment determine whether it’s tax-exempt. According to Tax Implications of Settlements and Judgments:
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The two most common exceptions are amounts paid for discrimination and physical injury.
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Gross income doesn’t include damages received from personal physical injuries.
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Taxpayers can exclude damages other than punitive from gross income on account of personal injuries or physical sickness.
If you’re unsure whether your settlement or parts of it are taxable, consult a CPA or tax professional. They can help you determine:
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The total amount received
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Settlement type: lump sum or structured payments
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Any taxable portions
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The deduction of attorney fees, if not already deducted
Best Ways to Use Your Settlement Money
Once your settlement money lands in your bank account, think about the best strategies to secure your financial stability.
Pay Off Debts
If you have any outstanding debts, such as medical bills, credit cards, and loans, use your settlement money to pay these off first and foremost. Not only can doing so reduce stress, but it can also save you money on interest. Once your debts are paid, you can focus on making your money go further.
Create an Emergency Fund
There may come a time when you’re faced with an unexpected expense that you haven’t budgeted for. Rather than disrupting your long-term financial plans, ensure you can cover those costs with an emergency fund. An emergency fund is typically enough money to cover three to six months’ worth of everyday living costs for a single household with low job security.
Invest for Future Growth
You’ve paid off your debts, set money aside for emergencies, and it’s now time to invest the remaining portion of your settlement funds. Most investment experts recommend a mix of stocks, real estate, and bonds to balance risk and protect against market fluctuations and uncertainty.
Define Your Goals
Before choosing investments, start by defining your goals. Determine your preferred investment timeframe and what you hope to achieve from investing your money. This planning phase can guide you toward the most suitable investment types for your needs. Many people define their goals as being:
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Generating investment income
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Retirement
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Buying a home
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Education
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Medical expenses
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Wealth preservation
Work with Professionals
Going from living paycheck to paycheck to receiving a significant legal settlement can result in feelings of overwhelm. You may know that you want your money to go further, but you don’t yet have the knowledge or skills to make it happen. As a result, there is great value in working with industry professionals.
CPAs, fiduciary financial advisors, and estate planning attorneys are all helpful people to talk to. If you received a particularly complex settlement, it can also be wise to contact a tax attorney. Aligning yourself with professionals can help ensure your investments align with your goals and, in some cases, minimize taxes.
Choose an Investment Strategy
Your goals will ultimately determine your investment strategy, with some investment types more suitable for short- or long-term investing.
Conservative Investment Strategy
Conservative investment strategies are those that protect your principal while offering steady returns. Many sound options fall into this category:
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Treasury bills
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High-yield savings accounts
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Money market funds
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Certificates of deposit (CDs)
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Municipal short-term notes
Balanced Investment Strategy
If you intend to invest your hard-won money for a mid-range period of five to 10 years with growth potential but reduced volatility, a balanced investment strategy can be recommended:
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Stock ETFs or mutual funds
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Bond funds
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Real estate investment trusts (REITs)
Strive for 60% to 70% in stocks for growth and 30% to 40% in bonds and cash for stability.
Growth Investment Strategy
Long-term investments typically enable you to tolerate greater market fluctuations. As a result, you can feel confident investing in a wider pool of options:
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S&P 500 index funds
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Large-cap growth ETFs
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Sector-specific funds (healthcare or technology)
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Real estate
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Individual growth stocks
Diversify Your Investments
Many beginner investors make the mistake of concentrating all their investments in one asset, industry, or company because it’s a high performer. However, being a high performer now doesn’t mean it will always be that way. Reduce investment risk by diversifying your investments. A balanced, diversified portfolio typically has a combination of:
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United States and international stocks
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Bonds
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Treasury securities
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Cash reserves
Avoid Common Settlement Fund Mistakes
Discover common settlement fund pitfalls that can lead to financial loss.
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Overspending on non-essential items
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Not paying off debts and building an emergency fund first
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Not putting a financial plan in place to allow for taxes and to avoid overspending
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Making investment choices based on social media trends
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Chasing high returns without considering other factors
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Choosing high-fee investment products
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Lending large amounts of money to friends and family without careful consideration
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Making emotional financial decisions right after receiving your settlement
Protect Your Wealth
Over time, and as your investments start to pay off, you may begin to accumulate wealth and assets. Just as important as building your wealth is protecting it. Several strategies can be worth exploring, including:
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Purchasing health, disability, home, and auto insurance to protect against costly disasters
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Adding liability protection if you have a high net worth
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Keeping a clear and current will, as well as establishing an enduring power of attorney
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Separating your personal wealth from business or property assets through LLCs or family trusts
Through a legal settlement, you have an opportunity to strengthen your financial future. Understand your tax obligations, explore a range of investment options, and don’t underestimate the value of diversification and wealth protection. The actions in this guide may serve you well as you preserve and grow your wealth for years to come.
