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All About Taxes on Lawsuit Settlements

Representation in civil lawsuits doesn’t come cheap. In the best-case scenario you’ll be awarded money at the end of either a trial or a settlement process. But before you blow your settlement, keep in mind that it may be taxable income in the eyes of the IRS. Here’s what you should know about taxes on lawsuit settlements. 

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The Different Kinds of Lawsuit Settlements

If you get a settlement from a lawsuit it could be for one of a few reasons. You could receive damages in recognition of a physical injury, damages from a non-physical injury or punitive damages stemming from the defendant’s conduct. In the tax year that you receive your settlement it might be a good idea to hire a tax accountant, even if you usually do your taxes yourself online. The IRS rules around which parts of a lawsuit settlement are taxable can get complicated.

Related Article: How to Find a Tax Accountant

Taxes on Lawsuit Settlements

All About Taxes on Lawsuit Settlements

The tax liability for recipients of lawsuit settlements depends on the type of settlement. In general, damages from a physical injury are not considered taxable income. However, if you’ve already deducted, say, your medical expenses from your injury, your damages will be taxable. You can’t get the same tax break twice.

In some cases, you may get damages for physical injury stemming from a non-physical suit. For example, if you win a libel suit and get damages for the doctors you saw about your stress-induced headaches after being libeled, the damages for those medical expenses are not taxable, assuming you haven’t already deducted them from your taxes. Although emotional distress damages are generally taxable, an exception arises if the emotional distress stems from a physical injury or manifests in physical symptoms for which you seek treatment.

In most cases, punitive damages are taxable, as are back pay and interest on unpaid money. Damages you receive for emotional distress are also taxable, with the exceptions noted above. And here’s the kicker: you owe taxes on the full amount that you’re awarded, including any attorney fees. That’s right – even if you don’t take the money home it’s still part of your award and subject to taxes. And if the opposing side is ordered to pay your attorney’s fee, that fee is considered taxable income, too. Depending on the type of suit you filed, you may be able to deduct your attorney fees when you fill out your tax returns.

Related Article: All About Tax Liability

Bottom Line

All About Taxes on Lawsuit Settlements

You might need a tax accountant or tax lawyer to help you navigate the post-settlement process and stay on the right side of the law. However, you don’t have to be an expert to see that it’s wise to set aside part of your settlement to cover the tax bill. Receiving a settlement could bump you up to a higher tax bracket and leave you with a much bigger April bill than you usually get.

If you’ve already blown through your settlement by the time tax season comes along, you’ll have to dip into your savings or borrow money to pay your tax bill. To avoid that situation, consult an expert and deal conservatively with your settlement funds. This might be an instance where it’s helpful to consult a financial advisor. The SmartAdvisor matching tool can help you find a person to work with to meet your needs. First you’ll answer a series of questions about your situation and your goals. Then the program will narrow down your options to three fiduciaries who suit your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.

Photo credit: ©iStock.com/stevecoleimages, ©iStock.com/Avosb, ©iStock.com/piranka

Amelia Josephson Amelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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