Going to court can sometimes be a lengthy and stressful process. By the end of this process, you probably don’t want to add any more extra stress to your life.
So if you’ve been awarded money as part of a lawsuit settlement, you probably want to know if it’s taxable or not and whether you’ll need to file it as part of your tax return.
Well, most money that is awarded throughout a lawsuit will be taxed by the IRS.
You’ll want to ensure that you are obeying all the correct tax codes and laws because there can be serious consequences to getting it wrong.
I’d always recommend reaching out to a financial advisor especially if you’re getting a 6-7 figure sum from your settlement.
While most settlements and damages that are paid will be considered as income (meaning they will be taxed) there are always exceptions to the rule.
A lot of personal injury settlements will be non-taxable.
We’ll go through which settlements are and are not taxable throughout this article, but it is important to remember there are always exceptions to the rules and you should always double-check your personal settlement.
Legal Settlements That Are Nontaxable
The following are usually nontaxable:
Physical Injury Settlements
Now, this isn’t always the case, but more often than not a physical injury award will not be taxed.
According to the IRS as long as the case shows observable bodily harm then the settlement will not be taxed.
So essentially, if you’ve been injured and it’s visible that you’ve been injured you can enjoy a tax-free settlement.
Car Accident Injury Settlements
If you get into a serious car accident, pretty much all settlements tend to be nontaxable.
Most lawsuits that are managed by personal injury lawyers are an anomaly to any settlement awards that consider income.
It’s important to keep in mind that your fees may be taxed if your lawyer charges you contingency fees.
This is rarely the case though with car accident lawsuits, or many personal injury cases such as slips and falls, these fees tend not to be taxed.
Medical Expenses (With No Previous Deduction Taken)
Most medical visits for either physical injury or emotional distress are usually nontaxable as long as you didn’t accept an enumerated deduction for said expenses in previous years.
If you settle while also being reimbursed for your medical expenses after accepting a deduction in prior years, it’s almost certain that you’ll have to pay tax.
This is part of a particular IRS rule that is known as the tax benefit rule.
Emotional Distress Awards
For an emotional distress award to be nontaxable you must meet one requirement. The emotional distress must originate from the sickness or injury as a result of the accident.
Keep in mind that any medical expenses that you incur will also be subject to the terms above and the deductions may be taxable once the settlement is reached.
It’s really important to make the distinction between it being a result of the injury or sickness though because if it is not the money will be taxable.
Legal Settlements That Are Taxable
If your settlement didn’t match one of the specific examples above, it’s more than likely that you will need to pay tax on the money you receive.
Punitive Damages And Interest
Any pre or post-judgment interest on your settlement money will be taxable. This can therefore influence the taxes on many attorney fees.
This is the same for any punitive damages that you may have been awarded. It can all get very complicated – it’s honestly within your best interest to refer to a financial professional to help you.
Loss Of Earnings
Sometimes through a settlement, you can claim money under lost wages but this money will be taxed.
The reasoning for this is that if you hadn’t lost those wages because of your issue, those wages would have been taxed, so this money should be too.
So this money will be treated much like your payslip, you’ll likely be subject to social security and Medicare taxes too.
If you have received a settlement recently I would recommend that you keep track of all the documentation that you are given.
It is really easy to misplace the one important document among the many that you may have received, but it’s really vital that you don’t.
Keep a filing system where all the information is easily accessible. There is likely to be information on these documents that you or your accountant is going to need when it comes to sorting your tax at the end of the year.
The answer to are settlements taxable isn’t a simple yes or no. There are many factors that can change whether or not you’ll need to pay tax on your settlement.
In most cases, you will need to pay tax on your settlement. There are only a handful of circumstances where you won’t need to pay tax and these are usually to do with personal injury claims.
It can be really confusing to know whether or not you need to pay tax, especially in instances such as these, but hopefully, this article has helped you understand the circumstances where you might or might not need to pay tax.
However, it is really important to recognize that each case is different from another and while it is the general rule it is not set in stone. There can always be exemptions to the rules.
If you are struggling with your tax, or if you are looking at quite a large sum of money for your settlement, I would recommend speaking to an accountant and getting them to help you ensure your tax forms are one hundred percent correct.
It’s better to be safe than sorry, especially when there can be such strong implications from getting it wrong.