Settlement Funds: Investing For The Future With Caution

Investing a settlement fund can be a great opportunity to benefit from compound interest and watch your money grow. However, it's important to understand the tax implications, as some settlements are taxable. For example, lawsuits about lost wages or punitive damages are typically taxable, whereas settlements from personal or physical injury are usually non-taxable.

To make the most of your settlement fund, it's recommended to get a good financial advisor, pay off any debt, and save for the future. This could include creating an emergency fund, investing in education, or putting money into a retirement fund. It's also worth considering investing in the futures market, which involves registering an account with a clearance house and buying or selling futures contracts.

Before investing, it's crucial to educate yourself on the various investment options available, such as index funds, real estate, or business ventures, and to be mindful of any hidden fees or commissions.

Understand tax implications

The tax implications of your settlement funds will depend on the nature of the settlement. According to the Internal Revenue Service (IRS), the general rule regarding the taxability of settlement funds is outlined in Internal Revenue Code (IRC) Section 61, which states that all income is taxable, regardless of its source, unless specifically exempted by another section of the code.

One such exemption is outlined in IRC Section 104, which states that gross income does not include damages received on account of personal physical injuries or physical sickness. This means that if your settlement funds are the result of a personal injury or physical sickness, they are typically non-taxable. This includes car accident injury settlements and certain discrimination claims.

On the other hand, settlements related to lost wages or punitive damages are typically taxable. Punitive damages are assessed to punish a defendant and are generally taxable. However, there is an exception for wrongful death claims where state law only provides for punitive damages. In such cases, refer to IRC Section 104(c) for the exclusion of punitive damages from taxation.

It is important to note that not all amounts received from a settlement are exempt from taxes. The key question to ask is: "What was the settlement (and its corresponding payments) intended to replace?" The facts and circumstances surrounding each settlement payment must be considered to determine the purpose for which the money was received.

Additionally, if you invest your settlement funds, the earnings may be subject to taxation. For example, if you invest in stocks or bonds, the dividends earned are fully taxable. If you invest in mutual funds, there may be tax consequences when the fund sells investments it is holding. You may receive a taxable dividend distribution, even if it is unwanted, if the fund's sales result in an overall gain.

To fully understand the tax implications of your settlement funds, it is recommended to consult a lawyer, tax attorney, or Certified Public Accountant (CPA). They can provide personalized advice based on your specific situation and help you navigate the tax rules and regulations.

Get a financial advisor

Getting a financial advisor is a great way to help you manage your settlement funds and ensure you're making the right decisions for your future. Here are some tips to help you get started:

Identify Your Financial Needs

Firstly, it's important to understand what you need from a financial advisor. Reflect on your financial goals and what areas you need help with. Do you need assistance with creating a budget, saving for specific goals, debt management, investing, tax strategy, retirement planning, or estate planning? Knowing what you need help with will help you find an advisor who is a good fit for your financial situation.

Know What Credentials to Look For

Not all financial advisors have the same qualifications or expertise. Look for advisors with certifications or expertise in the areas you need help with. Two common credentials to look out for are:

• Certified Financial Planner (CFP): CFPs have a fiduciary duty to their clients, meaning they are legally obligated to act in their client's best interest.
• Registered Investment Advisors (RIA): RIAs are individuals or companies that provide investment advice and are also bound by a fiduciary duty. They are registered with and regulated by the U.S. Securities and Exchange Commission or state regulators.

Review Financial Advisor Service Types

Financial advisors offer their services through different models, including online financial planners, traditional in-person financial planners, and robo-advisors (digital services offering automated investment management). Consider your preferences, the level of personalization you need, and your budget when choosing a service type.

Consider the Cost

Financial advisors have different cost structures, and it's important to understand how much their services will cost you. Robo-advisors and online financial advisors are typically more affordable, while traditional in-person advisors can be more expensive. Some advisors charge a percentage of the assets they manage for you, while others charge flat fees, hourly rates, or retainers. Ask about their fee structure and get specific dollar amounts to understand the cost better.

Vet the Financial Advisor's Background

Don't forget to research the advisor's background and credentials. Check their Form ADV, which outlines their ethical principles, potential conflicts of interest, and fee structure. You can also review their employment record and look for any disciplinary actions on the FINRA's BrokerCheck website. Ensure they are licensed in your state and have the necessary qualifications to provide the services you need.

Hire the Financial Advisor

Once you've found an advisor who meets your needs and passes your background check, it's time to hire them. They will typically provide a consultation to discuss your financial situation and goals. After that, they will provide you with the necessary legal documents and start working on managing your finances and investments.

Pay off debt

If you've received a settlement, paying off any existing debt is a great way to use that money. Here are some tips on how to do that effectively:

Understand the tax implications

Before you do anything, it's important to understand the tax implications of your settlement. While compensation for personal physical injuries is usually non-taxable, most other settlements are considered income and are therefore taxable. Consult a tax professional to understand your specific situation and set aside money for taxes if necessary.

Prioritize high-interest debt

Focus on paying off credit cards and other high-interest debt first. These debts cost you the most in the long run, so eliminating them should be a priority.

Deal with remaining debt

After addressing high-interest debt, turn your attention to any remaining debts. This includes secured accounts like mortgages and car loans, as well as debts to friends and family. Getting these accounts back in good standing will improve your credit score and give you some financial breathing room.

Improve your credit score

A settlement can be an opportunity to improve your credit score. Pull your credit reports and dispute any inaccuracies. Then, focus on adding positive credit information by making timely payments and keeping credit card balances low.

Prepare for the future

Finally, don't forget to save for the future. Set aside a portion of your settlement for emergencies, retirement, and other long-term goals. This will help reduce financial stress and improve your overall financial health.

Using a settlement to pay off debt can be a smart financial move. By following these steps, you can improve your financial situation and set yourself up for a more secure future.

Save and invest

If you've received a large sum of settlement money, it can be a scary and intimidating time, especially if you've never had to manage a large amount of money before. It's important to be aware of the emotional impact of receiving a large sum of money, which can cloud your judgment.

The first thing to do is to get a handle on the tax implications of your settlement money. Consult a lawyer, tax attorney, or CPA to understand if your settlement is taxable. Once you know how much money you have to play with, you can start to plan.

The next step is to create a financial strategy. A financial advisor can help you with this, and they can also act as a buffer between you and any friends or family members who may come knocking. A financial advisor will help you to create a plan that works for your life goals. For example, you may want to put money aside for your child's college fund, or to enable you to retire early.

The next steps are to pay off any debt and to save. First, pay off credit cards, medical expenses, and high-interest loans. Then, create an emergency fund of at least six months' living expenses. Next, pay off your mortgage or any other loans. Finally, set aside money for your retirement fund.

Now that you've dealt with the essentials, you can start to think about investing. You could invest in education, either for yourself or your children. You could also invest in your home, whether that's through purchasing property or making improvements to your current home.

There are many options for investing your settlement money, and it can be overwhelming. You could invest in stocks, bonds, or real estate. You could also invest in a business, or even in friends or family, but be sure to do your research and go through the proper legal channels.

Settlement money can be life-changing, and with the right strategy, you can make the most of it.

Plan for retirement

Planning for retirement can be challenging, and many working Americans say they are behind on their retirement savings. Here are some tips to help you plan for retirement using settlement funds:

• Defined contribution plans: These include 401(k)s, 403(b)s, and 457(b)s, which are offered by various employers. Contributions are typically made with pre-tax wages, allowing tax-free growth until retirement. Withdrawals before retirement age may result in taxes and penalties.
• Traditional pensions: These are defined benefit plans funded by employers, providing a fixed monthly benefit to retirees. However, they are becoming less common.
• Guaranteed income annuities (GIAs): Individuals can purchase these annuities to create their own pensions. While some opt for immediate annuities, most prefer deferred income annuities, which are paid into over time.
• The Federal Thrift Savings Plan (TSP): This plan is similar to a 401(k) but is available to government workers and offers additional low-cost investment options. Federal employees can also receive employer contributions to their TSP.
• Cash-value life insurance plans: Offered by some companies as a benefit, these plans provide a death benefit while building cash value that can support retirement needs. Withdrawals of the cash value are typically tax-free.
• Non-qualified deferred compensation plans (NQDCs): These are typically offered to top executives and provide tax-deferred savings opportunities. However, they may not offer the same level of security as other plans.
• Health savings accounts (HSAs): While created for healthcare expenses, HSAs can also function as supplemental retirement accounts, offering tax advantages similar to traditional IRAs.
• 529 education savings plans: While intended for education expenses, these plans can now be used to fund a Roth IRA, providing additional flexibility for retirement savings.
• Individual retirement accounts (IRAs): IRAs are valuable retirement plans that offer significant tax advantages. Traditional IRAs allow contributions with pre-tax dollars, while Roth IRAs use after-tax contributions but offer tax-free withdrawals in retirement. Spousal IRAs enable non-working spouses to take advantage of IRA benefits.
• Rollover IRAs: These allow individuals to move funds from an existing retirement account, such as a 401(k) or IRA, to a new IRA, preserving tax benefits.
• SEP IRAs and SIMPLE IRAs: These are designed for small business owners and their employees, offering higher contribution limits and profit-sharing opportunities.
• Solo 401(k)s: Designed for business owners and their spouses, solo 401(k)s allow for higher contributions and include both elective deferrals and non-elective contributions.

When planning for retirement, it is essential to consider your specific circumstances, risk tolerance, and time horizon. Consulting with a financial professional can help you determine the most appropriate strategies and plans for your retirement goals.

Frequently asked questions