8 Smart Things to Do With Your Settlement Money

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So, you're experiencing a financial windfall? Sold a business or property, won a lucrative contract, or were awarded money in a lawsuit? Congratulations! You're probably feeling a mixture of relief and anxiety.

Now, how do you go about making sure that you don't lose or spend absolutely everything within the next few years? That's what happens to most people who receive a large cash settlement if they don't know how to manage it properly. Here's how to avoid that outcome:

1. Understand the Tax Implications

Getting a handle on how much your windfall may be taxed is a crucial first step in managing your money.

"It's almost always best to get tax advice before finalizing (and documenting) the terms of a settlement," says Benjamin L. Grosz, a tax and estate planning attorney at Ivins, Phillips & Barker in Washington, DC. "Under federal tax law, most types of settlements (or judgments) will be subject to income taxes."

Exceptions usually include settlement payments for personal injuries or physical sickness, says Grosz. Emotional distress settlements can go either way.

Your settlement may be subject to taxes if it is related to the following type of claim: breach of contract, copyright infringement, lost profits, back pay, or punitive damages. You may also have to pay taxes on top of attorney's fees. Also, your settlement might be a combination of taxable and tax-free.

Financial Planner Drew Weckbach offers the following example of a $100,000 mixed-tax settlement: "The first $40,000 may be due to the personal injury and reimbursement of expenses; this is tax-free. The next $60,000 may be deemed punitive for the negligence of the offending party; you would have to pay taxes on that portion."

2. Get a Good Financial Advisor

Martin Hurlburt, author and co-founder of TM Wealth Management, points out something that is frequently overlooked by settlement recipients. "The most important thing to remember when managing a sudden windfall is that emotions can be hazardous to your wealth! You may feel relief and grief at the same time. Guilt and happiness. And in this mixed up state of mind, you will be asked to make some important and potentially life-changing decisions."

Because of the emotional rollercoaster that a financial windfall can cause, Hurlburt recommends that you sit down with a financial advisor who specializes in sudden wealth management. "Create your [financial] strategy," says Hurlburt. "Have a plan for the money before you get it."

Also, be sure to find a financial advisor who is willing relieve some of the personal pressure that inevitably comes from suddenly finding yourself flush with cash.

"When friends and family come to you for money, you can legitimately tell them you need to run it by your advisor first," advises Hurlburt. "Let the advisor be the 'bad guy' or person who says 'No.'"

3. Pay Off Debt and Save

These steps might seem obvious, but sometimes large financial windfalls can skew one's perception of financial obligations. However, it may help to think about using your settlement money the same way you might use your regular income; at least, in the beginning.

First, pay off debt, such as credit cards, lingering medical expenses, and high-interest loans.

Once this is done, you can create your emergency fund (a minimum of six months of living expenses — this will help you stay out of debt in the future). Next, you can pay off other debt, such as your home mortgage or car loans. Fourth, set aside your retirement fund. Your financial advisor can help you decide what the best investment type will be for you and your situation.

Finally, consider what kind of estate planning you will need and decide how your remaining money will be used when you die. Talk to an expert about this.

4. Invest in Education

Kevin Gallegos, Vice President of Phoenix operations for the Freedom Financial Network, recommends investing in education next. Besides putting money into education funds for your children, you can "build your own financial future by continuing your education," says Gallegos. "Higher education generally repays its cost — and then some." Receiving the best education you can is not just financially rewarding, it is personally fulfilling.

Even if you have enough of a windfall to stop working for a time, you may find that you want to volunteer or even continue working — earning a degree in an area that you find interesting can turn your job into something you are excited to do (assuming you don't already have a job like this — most of us don't).

5. Invest in Your Home

After educational costs, says Gallegos, consider your living situation. "If you do not own, it may be an opportunity to purchase a home. No matter what, though, it is still important to research the total costs of owning, your lifestyle and priorities, and make a careful decision before proceeding."

"A house is important, but don't over extend yourself," cautions Layton Cox, Financial Advisor for Pathways Financial Partners. "Buy something in your price range with a monthly mortgage payment you can afford."

Don't forget to consider the cost of property taxes in the area that you want to live.

6. Donate to Charity

Charitable donations are tax-deductible, so giving to charity isn't just a feel-good way to spend part (or all) of your settlement, it's a smart financial decision. Besides direct gifts, you can ask your tax advisor about setting up a charitable trust.

7. Invest in Business, Friends, or Family

If you have personal projects or family relations that you believe deserve a cash infusion, you don't have to hoard your money, but invest wisely. Do your research, lean on your financial advisor, and make sure to go through the proper legal channels to ensure that you don't get stuck owing money to someone you don't even know because your cousin Roger jerked you around.

8. Enjoy Yourself!

Of course, when imagining a financial windfall, most of us do spend time dreaming about all the cool stuff that money can buy. But instead of the fancy cars or boats that we typically fantasize about, consider treating yourself to new and exciting experiences, rather than simply material goods.

In other words, avoid a "keeping up with the Joneses" mentality.

Cox, of Pathways Financial Partners, advises, "Everyone wants the new car, the new suit, the new home, or anything their neighbor has that is better than theirs. [But] when it comes to a dollar-for-dollar comparison, people enjoy experiences more than possessions."

"If you still have extra money laying around," says Cox, "take a vacation. I've been told the Maldives are beautiful this time of year… or any time of year."

Have you been lucky enough to receive a financial windfall? How did you manage it?

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