It’s been a summer of settlements, with major companies such as Equifax, Capital One, and Amazon paying out millions — even billions — of dollars to consumers.
Whether you’ve been involved in a class action lawsuit, a personal injury lawsuit, or other type of case, settling out of court can result in a major windfall. And having a plan for what to do with that money can set you up for financial success for years to come.
Understanding your settlement
The amount you can expect to receive from a settlement depends on the nature of the case.
For example, a class action settlement is an agreement that resolves a lawsuit brought by a group of people who experienced the same (or similar) harm from a company or other organization. The resulting payment may be distributed to each person as one lump sum or in structured installments over time.
However, the payment is based on the number of people affected and the amount of the damages sustained. So, even in the case of a multi-million dollar settlement, your payment may only be a few dollars if many people were involved.
In other situations, you may be the sole plaintiff, such as in a medical malpractice or personal injury case. You could potentially receive thousands of dollars.
It’s important to note that regardless of the type of settlement, that money is generally considered taxable income, unless it falls within an exempt category, such as compensation received for personal physical injuries and proceeds received for emotional distress or mental anguish. So, before you start spending your settlement money, it’s crucial to factor in how this windfall will impact your tax bill and set aside a portion for tax time.
You’ll also want to factor in any outstanding bills, attorney fees, or other case-related expenses.
Best ways to use a settlement payment
Once you know the amount of your settlement after taxes and fees, you can make a plan for how to best use those funds. It may be tempting to go on a shopping spree or take a lavish vacation, but taking advantage of this opportunity strategically can greatly improve your financial situation.
1. Catch up on essential bills
As the cost of living continues to rise at an above-average pace, many Americans are feeling the pinch and struggling to keep up on living expenses. Receiving a settlement payment could be the key to catching up on your bills and giving your budget some much-needed breathing room.
As you’re getting your financial house in order, prioritize paying off overdue bills first to avoid late fees, interest, and damage to your credit scores.
2. Pay off high-interest debt
If you’re carrying any high-interest debt, such as credit cards or payday loans, paying down those balances could save you a significant amount of interest over time.
For example, say you have a $10,000 credit card balance at 23% APR with a monthly payment of $300. It would take you about 4.5 years to pay off your credit card, and you will have paid over $6,000 in interest.
However, say you receive a $3,000 settlement payment, and you use that money to immediately lower your balance to $7,000. Assuming you continue paying $300 per month, you’d be debt-free in just under three years and have saved $3,600 in interest.
3. Pad your emergency fund
According to the Federal Reserve’s Survey of Household Economics and Decisionmaking, only 55% of adults have three months’ worth of savings in their emergency fund. And only 63% say they could cover a $400 emergency expense using cash rather than alternatives such as a credit card, payday loan, or borrowing money from a friend or family member.
Not having an emergency fund can leave you vulnerable to unexpected expenses and force you to take on extra debt.
Using a settlement to boost your emergency fund ensures that when the unexpected happens, you’ll be able to cover the cost without putting yourself in a worse financial position.
4. Start earning more interest
Maybe you’re not sure how you want to use your settlement money yet — that doesn’t mean you can’t put it to work immediately. Parking cash in a high-yield savings account, money market account, or certificate of deposit (CD) allows your balance to generate interest and grow at a faster rate.
For example, say you receive a $5,000 settlement payment and you put that money in a high-yield savings account that earns 4% APY. Even if you make no additional contributions to that account, you will earn roughly $200 in interest over the course of one year.
5. Invest for long-term goals
If your immediate finances are in good shape, investing some of the money could help it grow even faster over time.
Investing offers greater growth potential than keeping all of the money in a savings account, although it also comes with the risk of losing money. The good news is that the longer you keep your money invested, the more time you have to recover from market fluctuations and allow your returns to compound.
Depending on your goals, you may decide to increase retirement contributions or invest through a taxable brokerage account. And you don’t need to be an expert stock-picker; a diversified, low-cost index fund or ETF can provide exposure to many investments at once rather than betting a large portion of your settlement on a handful of individual stocks.
Common settlement mistakes to avoid
Whether it’s a holiday bonus, tax refund, or settlement payment, receiving a windfall can be exciting. Don’t let that excitement cause you to make decisions that end up backfiring:
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Making large impulse purchases: There’s nothing wrong with using a portion of your settlement for a splurge. However, even splurges require some planning. Review your current financial situation first to determine how much you can truly afford to spend up front, and set the rest aside.
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Lending money to friends and family without a plan: You may be tempted to share the wealth with loved ones, but again, having a clear plan in place is key. If you decide to lend money to friends or family, make sure you’ve taken care of your own pressing financial priorities first. Then determine how much you can afford to lend and what repayment should look like to ensure you recoup that money.
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Trying to time the market with a large lump-sum investment: The stock market is unpredictable, and there are no guaranteed outcomes when investing. In general, investing a portion of your settlement is a smart way to generate wealth, but you should only invest as much as you’re willing to lose in the short-term.
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Ignoring taxes or future financial obligations: Settlement money often comes with hidden costs such as taxes and fees, which need to be accounted for before you start spending. You’ll also want to consider your financial obligations beyond today and create a forward-thinking plan for covering future expenses.
