What You Need to Know 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 spend 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. Consider working with a financial advisor who can help you optimize a tax strategy for your lawsuit settlement.

What Are the Different Kinds of Lawsuit Settlements?

Lawsuit settlements can generally be categorized into compensatory and punitive settlements, each serving a distinct purpose. C

Compensatory settlements aim to reimburse plaintiffs for specific losses, such as medical expenses, lost wages or emotional distress. Within this category, settlements for physical injuries or illnesses are often tax-free under federal law, while those for non-physical damages, such as emotional distress without accompanying physical injury, may be taxable.

Punitive settlements, on the other hand, are awarded to punish the defendant for particularly egregious conduct and to deter similar behavior in the future. These are almost always considered taxable by the IRS, regardless of the circumstances.

Understanding the type of settlement helps determine its tax treatment, as different rules apply to each. Reviewing the breakdown of settlement categories with a tax professional can provide additional clarity.

How Taxes on Lawsuit Settlements Work

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 above as well. And here’s the kicker: you owe taxes on the full amount that you receive, 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 has to pay your attorney’s fee, that fee is taxable income too. Depending on the type of suit you file, you may be able to deduct your attorney fees.

Lost Wages Are Taxable

If a portion of your settlement is allocated to cover lost wages, that amount is subject to taxation just like regular income. The IRS treats lost wage compensation as a replacement for the income you would have earned, which means you’ll owe taxes at your normal income tax rate. Additionally, these amounts may be subject to Social Security and Medicare taxes.

Reporting Settlement Income

If a portion of your lawsuit settlement is taxable, it must be reported as income on your federal tax return. The exact reporting requirements depend on the nature of the settlement. Compensatory damages for lost wages, for example, are typically reported as wages on your Form 1040 and may be subject to employment taxes. Punitive damages and awards for interest on settlements are reported as “Other Income” on Schedule 1 of Form 1040.

You may receive a Form 1099-MISC from the payer of the settlement if the taxable amount exceeds $600. This form outlines the income received, including any taxable portion. If the settlement includes attorney fees, you may need to report the full gross amount even if a portion was paid directly to your lawyer.

Non-taxable settlement components, such as compensation for physical injuries, generally do not need to be reported. However, clear documentation distinguishing taxable and non-taxable portions is crucial. Failing to properly report settlement income can result in penalties or additional taxes. Consulting a tax advisor can help you ensure compliance and accurately complete your return.

Bottom Line

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.

Tips for Managing Your Taxes

• Let’s say you’ve already spent your settlement by the time tax season comes along. In this case, you’ll have to dip into your savings or borrow money to pay your tax bill. A financial advisor can potentially help you create a financial plan to avoid that situation. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• There’s no better way to ensure your taxes are in good shape than to plan ahead. This is especially true if you end up owing the government. Use SmartAsset’s income tax calculator to learn more.

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