Dear Tax Talk,
What are the tax consequences on investment income from a disability policy payout? If the insurance company that pays my disability policy settles with me, after 13 years of paying benefits, for a lump sum — let’s say $400,000 — and I invest that money in some fund, I have been told the $400,000 is not taxable and that would make sense. But would the profits of that investment be taxable or would they be exempt? Also, and I guess the better question would be, is there a vehicle to put that money where the returns on investment would not be taxable?
— Hector

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Dear Hector,
How you invest the lump-sum payment from the disability company is going to determine whether there are tax consequences on the income it produces. The fact that the money is coming to you as the result of a disability settlement has no bearing on the taxability of income generated once you invest it. The determining factor will be the underlying investment.

For example, if you put the money in a bank certificate of deposit, it will generate taxable interest income for you. However, if you invest in tax-free municipal bonds, then the income will not be taxed.

Do the math

To determine if it makes sense to invest in municipal bonds, it’s a good exercise to compare their yields with those of taxable bonds. Since municipal bond yields won’t be reduced by taxes, how big must the yield on taxable investments be to match the yield of a municipal bond? The answer is found on Bankrate’s tax equivalent yield calculator.

I strongly recommend that you sit down with a qualified financial planner or broker and discuss your options on how you want to invest this income, especially since you will no longer be receiving any future payments from the insurance company. You have many options that are available to you, but unless the money is invested in “tax-free investments,” you could end up owing tax on dividends, interest or capital gains.

That is not necessarily a bad thing; keep in mind, some tax-free investments pay very low rates of return. You possibly could be better off having a higher rate of return from investments that are not considered tax-free, especially if you do not have a lot of taxable income from other sources.

Since I do not have more information on your particular situation, I am unable to give you a more concrete answer and feel confident that a professional can assist you as you move forward.

Thanks for the great question and all the best to you.

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