When receiving a legal settlement, one of the first questions that might come to mind is, “Will I owe taxes on this money?”. Whether you owe taxes or not on settlement money depends on whether the settlement payments are considered taxable or non-taxable. Understanding how taxes on settlements work is crucial to strategizing how to pay any taxes you may owe on a settlement or judgment.
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Does Settlement Money Get Taxed?
Taxpayers only owe tax money on settlements if the settlement payments are considered taxable. Settlement money that is considered to be includable in gross income is often, but not always, subject to federal employment taxes.
The type of settlement matters less than the purpose for the settlement payments when it comes to determining what is taxable. For example, take a class action lawsuit due to an employer failing to payout employment benefits during mass layoffs. The employer during the settlement has to compensate employees involved in the class action lawsuit for lost benefits. In this case, the lost benefits are taxable. In contrast, take a class action lawsuit due workers injured on site from exposure to toxic chemicals. The company has to compensate workers who sustained physical sickness or physical injuries for the settlement. In this case, the settlement payouts on account of physical sickness or physical injury make them non-taxable. While both scenarios are for class action lawsuits, the type of settlement payments are different, resulting in different tax obligations.
If you are unsure how much you owe, or if you owe, in taxes from a settlement, contact a tax professional. They can help you understand whether the payment you receive from a settlement is considered income, wages, or has a specific IRS reporting requirement. If you do owe money in taxes, they can help you strategize how best to pay back the IRS
Non-Taxable Settlements
Not all settlements and judgments are taxable. There are several exceptions to owing taxes for these payments, including:
- Mental or emotional distress on account of physical injury or sickness
- Punitive damages for wrongful death
- Personal physical injury directly causing the loss of wages or work benefits
- Any payments received for personal physical injuries or physical sickness
Compensation received for emotional distress, humiliation, and defamation are also exempt from federal employment taxes, although still generally considered to be gross income.
When determining how much of your settlement is exempt from taxes, it’s best to work with tax professionals who have an expert level of understanding when it comes to navigating IRS tax exemption rules. You do not want to incorrectly report taxable gross income to the IRS because of an improper calculation of taxable settlement money. At Priority Tax Relief, our team of enrolled agents, tax attorneys, and CPAs can help.
Taxable Settlements
Settlements and judgments are subject to taxes in a wide range of cases including:
- Most punitive damages, with the exception of wrongful death claims
- Dismissal pay, severance pay, or payments from involuntary termination, generally
- Emotional distress recovery, with the exception of claims on account of personal injury, physical sickness, or reimbursement of actual medical expenses
- Business or contract dispute settlements
There are some instances in which cases that are often exempt from taxable settlement compensation end up owing the IRS taxes. For example, car accident settlements from physical injuries are often exempt. However, if a victim of a car accident wins settlement compensation for emotional distress, but no physical injuries were sustained during the accident, the payouts are considered taxable.
A tax professional can help you calculate how much taxes you owe on your non-exempt settlement or judgment payouts, so you can safely file your tax return without getting into trouble with the IRS over missed taxable income reporting. If you have already filed your taxes and missed reporting taxable income from a settlement, contact our team of tax professionals for help filing an amended tax return.
Do You Have to Pay Taxes on a Settlement?
Now that you understand what is considered taxable and non-taxable settlement money, let’s explore strategies you can use to legally minimize or avoid paying taxes on your settlement money.
Proper Allocation of Settlement Funds
It’s crucial to structure your settlement agreement in a way that minimizes taxes. You and your attorney should work closely to ensure that the settlement agreement clearly states the nature of the payment. The IRS scrutinizes settlement agreements, and how your settlement is described can significantly affect its tax treatment. For instance, allocating a higher portion of the settlement to physical injury or medical expenses (if applicable) can help you avoid taxes as this would not be considered taxable income.
Medical Expense Deductions
As mentioned earlier, emotional distress settlements can in some cases be taxable, but you can reduce this tax burden by excluding any medical expenses related to the emotional distress. Keep thorough records of any medical treatments, prescriptions, or therapy sessions related to your emotional distress to support your deductions. This way, you can reduce the taxable portion of the settlement.
Structured Settlements
One popular way to minimize taxes on a large settlement is through a structured settlement. Instead of receiving a lump sum, a structured settlement spreads the payments over a period of years. This reduces your annual taxable income by helping you stay in a lower tax bracket. Structured settlements are used in physical injury cases to provide steady, tax-free income over time. For taxable non-injury cases, a structured settlement must be carefully established before the legal agreement is executed using a specialized assignment company; otherwise, the IRS will tax the entire lump sum immediately under the Constructive Receipt Doctrine.
Example: Instead of receiving a $1 million settlement in a single year (which could push you into a higher tax bracket), you may opt to receive $100,000 per year over ten years, reducing your tax liability each year.
Charitable Contributions
If you’re in a situation where part of your settlement will be taxed, consider offsetting this by making charitable contributions. Donations to qualified charities can reduce your taxable income, which helps lessen the tax burden from your settlement. This is particularly useful for high-net-worth individuals who receive substantial settlements.
Consider Tax-Free Investment Accounts
Investing your settlement money into tax-free or tax-deferred accounts such as a Roth IRA or 529 college savings plan can be an effective tax strategy. With a Roth IRA, your investments grow tax-free, and qualified distributions in retirement are also tax-free. For a 529 plan, qualified education expenses are not taxed, providing a good option for long-term planning.
Consult with a Tax Professional
The complexity of settlement taxes means you should always consult with a tax professional or attorney when receiving settlement money. They can help you structure the settlement in a tax-efficient manner and ensure you’re maximizing any available deductions or credits. Additionally, your tax professional can help you plan for estimated tax payments to avoid penalties and interest from underpayment.
While receiving settlement money can be a significant financial relief, understanding the tax implications and planning accordingly is crucial to avoid unexpected tax burdens. By knowing how settlements are taxed and employing smart tax strategies, you can minimize or even avoid paying taxes on your settlement money. Always work with a tax professional to ensure compliance with IRS regulations while optimizing your financial outcome.
If you’re navigating a settlement, the key takeaway is this: proper planning and professional guidance can make a huge difference in your tax liability. So, plan ahead and keep more of your hard-earned settlement money in your pocket.
