Do I Have to Pay Tax on Settlement Money? Top 10 Questions

HomeSettlement Tax PlanningDo I Have to Pay Tax on Settlement Money? Top 10 Questions

Are you wondering if you’ll have to pay tax on settlement money?

Are you afraid of being surprised by a huge tax bill on settlement money you thought was yours tax-free?

If so, you’re not alone! Settling a lawsuit is complicated enough WITHOUT having to worry about complex tax rules on your recovery.

Understanding if you’ll be taxed is crucial for keeping as much of your hard-won legal recovery as possible. A little tax planning can make a huge difference.

So if you have questions like:

  • “Will I owe taxes on my settlement?”
  • “Can I deduct my legal fees?”
  • “Are there any tax planning strategies I can use to pay less in taxes?” 

This blog post is for you.

Here are ten frequently asked questions from plaintiffs nationwide about whether money from a legal settlement is taxable.

Please note: the information shared today is intended for general informational purposes only and is not intended to be tax advice.

Question 1: What’s the default rule about paying taxes on settlement money?

The default rule is that legal settlements and judgments are taxable income unless the recipient can prove otherwise, and an exception applies. 

The burden is on the plaintiff to prove that part, or all, of their settlement money should not be taxed based on specific rules in the tax code (like Section 104, which we will discuss soon).

Otherwise, the default assumption by the IRS is that the entire settlement, including the amount paid to your attorney, must be reported as taxable income on the plaintiff’s tax return in the year received. 

Unless you can clearly demonstrate through documentation and allocation in the settlement agreement that some of the money falls into a category of settlements that aren’t taxed, it’s usually assumed that all of the settlement money needs to be reported as taxable income. 

Question 2: What is the “origin of the claim” rule? 

The “origin of the claim” rule refers to the idea that settlements and judgments are taxed based on the underlying claims made at the initiation of a case, regardless of how the case eventually resolves. 

For instance, if someone sues primarily for lost business profits and the case settles, the proceeds will be taxed as lost profits (ordinary income), even if the settlement agreement doesn’t say that specifically.

The reason you started the lawsuit in the first place determines how the money you get from the settlement or judgment is taxed. In other words, how you’re taxed depends on the main issue at the origination of the lawsuit. That’s why this rule is called the “origin of the claim.”

This rule applies even if the case settles quickly or if a full-fledged lawsuit is never filed. How the legal claim is described when it first starts determines the tax result.

Question 3: Are personal injury settlements taxable?

In most cases, no. 

Common types of personal injury settlements include: 

  • Car accidents
  • Medical mistakes
  • Slips and falls 
  • Dog bites

Personal injury settlements are not taxable due to a listed exclusion in the tax code (Section 104). Section 104 is a major exception to the usual rule that says settlement money is taxable.

Section 104 excludes settlement money received for personal physical injuries and physical sickness. 

This means that money from the settlement for medical costs, lost wages, pain and suffering, and other losses from physical harm do not need to be reported as income. 

However, keep in mind that any extra money awarded to punish the defendant — called punitive damages — and any pre- or post-judgment interest awarded from your personal injury settlement is still taxed like regular income. 

Section 104 only helps with the money you get to compensate for the injuries you suffered (called compensatory damages), not the extra punitive damages or interest awarded before or after the court decision. (We’ll discuss more about this in Question 7.)

Question 4: Are employment settlements taxable?

Settlements and judgments for the following types of employment-related cases are fully taxable: 

  • Discrimination
  • Retaliation
  • Wrongful termination
  • Other workplace-related claims 

Employment settlements are fully taxable under the “origin of the claim” doctrine, and employment settlements do not qualify for the Section 104 tax exclusion because they typically do not arise from a personal physical injury or sickness. 

Even if you experienced emotional distress or physical symptoms due to workplace harassment or discrimination, the original nature of the injury — the origin of the claim — was not a physical injury, so money received from any settlement is considered taxable income. 

The only way an employment case settlement could be tax-free is if the claims included damages solely stemming from a physical injury or sickness suffered at the workplace. 

Absent a claim like a back injury from lifting boxes, employment cases do not originate from a physical injury, so the damages compensate for non-physical workplace wrongs and, therefore, are taxable.

Question 5: Is a settlement for lost wages or lost income taxable?

Yes. In an employment lawsuit, if part of the settlement is compensation for lost wages or lost income, that amount would be fully taxable as ordinary income.

So, if an employment settlement agreement states that a portion of the settlement is to compensate for back pay, front pay, or other lost wages, you’ll have to pay regular income tax on that portion. You’ll also have to pay the typical wage-related taxes such as FICA taxes (taxes for Social Security and Medicare).

Question 6: Is a settlement for emotional distress taxable?

Yes, damages awarded for emotional distress are generally taxable as ordinary income, even if you had physical symptoms due to the emotional harm. 

The tax code distinguishes between damages for physical injuries and emotional distress. 

For purposes of the Section 104 exclusion, physical symptoms like these are not considered “physical injuries or sickness”:

  • Headaches
  • Insomnia 
  • And stomach conditions like ulcers resulting from emotional distress 

This means even if emotional distress caused physical symptoms, any compensation you receive would still be taxable

The money you get for emotional distress can only be tax-free if it’s because of a physical injury or sickness, like a car crash or a medical malpractice claim. Basically, the origin of the lawsuit has to be about a personal, physical injury.

Emotional distress on its own, regardless of symptoms, does not qualify as physical harm and, as a result, would be taxable. 

Question 7: Are punitive damages or pre- or post-judgment interest taxable?

Yes, extra money given as punitive damages and any interest before or after the court decision is taxed like regular income. 

The Section 104 exclusion for physical injury damages does not apply to any punitive damages or pre- or post-judgment interest, even if they are awarded in a personal injury case.

Punitive damages are given to punish the egregious behavior of the defendant, not to compensate the plaintiff. They’re always taxed as regular income, no matter what the case was about. Even if you get tax-free money for physical injuries, any extra punitive damages money you get is always taxed.

Interest awarded by a court before and after a court judgment is also always taxed. This is because the interest money you receive is to pay for the lost value of money over time, not to compensate you for past losses. The IRS doesn’t allow any interest awarded to be tax-free.

Plaintiffs often run into trouble by assuming large verdicts are tax-free without considering the punitive damage and interest components.

Question 8: Can I deduct attorney fees if my settlement is taxable?

It depends. Once you’ve determined that your settlement is taxable, you next want to figure out if you can deduct your attorney’s fees. Otherwise, you’ll pay tax on 100% of the settlement, including the amount you pay to your attorney as legal fees.

If your settlement is taxable, your ability to deduct attorney’s fees depends on the type of case you’re involved in. 

Plaintiffs in employment discrimination or retaliation lawsuits are allowed to deduct legal fees “above the line,” which provides a full deduction for legal fees. Some whistleblower claims also permit this above-the-line deduction for legal fees. 

However, for most other taxable cases, the 2017 Tax Cuts and Jobs Acts removed the ability to deduct legal fees. (The Tax Cuts and Jobs Act removed miscellaneous itemized deductions, which is how plaintiffs had previously deducted their legal fees on their tax returns.)

This means that, for settlements related to most other taxable claims, there is no deduction available for legal fees paid to an attorney.

After 2017, individual plaintiffs pay tax on the total gross settlement amount, including the money paid to the attorney. There’s no “offset” or deduction for legal fees. 

Let’s look at an example: Assume there’s a $10 settlement. $4 goes to the attorney, and the plaintiff receives $6. You would think the plaintiff only pays tax on the $6 they receive, right? Wrong! After the Tax Cuts and Jobs Act, the plaintiff pays tax on the full $10, even though the plaintiff only gets $6. 

Tax on settlement breakdown
Tax on settlement after tax cuts and jobs act

What’s more, the attorneys also pay tax on the $4 they receive, so the attorney fee portion of the case is actually taxed twice. This is an unfair outcome we call the Plaintiff Double Tax Trap.

The Plaintiff Double Tax Trap continues to be a challenge for plaintiffs outside of employment retaliation, employment discrimination, and some whistleblower cases. But there is a solution to the Plaintiff Double Tax trap, which we will cover next in Question 9.

Question 9: Is there any way to avoid the Plaintiff Double Tax Trap if I can’t deduct legal fees?

Yes. There is one viable tax planning tool that can avoid the Plaintiff Double Tax Trap. 

The solution is called the Plaintiff Recovery Trust.

The Plaintiff Recovery Trust allows plaintiffs to avoid paying taxes on the attorney fee portion of their legal settlement in cases where those fees would otherwise not be deductible.

By excluding the attorney’s fees from the plaintiff’s taxable income, the Plaintiff Recovery Trust enables plaintiffs to keep a much larger portion of their settlement after taxes.

With the Plaintiff Recovery Trust, plaintiffs can often double — or even triple — how much money they get to keep after paying taxes. It is a powerful tax planning tool that we use with plaintiffs nationwide to dramatically increase what they get to keep after taxes!

Question 10: Are there any other tax planning strategies I can use to pay less in taxes?

Yes. One of the most powerful and common tax planning strategies we use with plaintiffs across the country is a structured settlement annuity

A structured settlement annuity provides significant tax benefits for plaintiffs receiving taxable settlement awards. A structured settlement annuity works in any case where the settlement is taxable, regardless of whether the plaintiff can deduct legal fees.

Here’s how a structured settlement annuity works: Rather than receiving the entire taxable settlement amount in one lump sum payment in the year of settlement, the settlement funds are used to purchase an annuity. 

Tax on settlement annuity payout

The annuity provides the plaintiff with regular payments over a set number of years in the future. This payment structure allows the plaintiff to spread out the taxable income — the settlement recovery — over multiple years. With an annuity, the plaintiff is ONLY taxed when they receive the annuity payments. 

This is significant because by spreading out the taxable income over multiple years, the plaintiff is usually taxed at a lower marginal tax rate each year rather than owing taxes all in one year at a much higher tax rate. This substantially reduces the total taxes the plaintiff pays over time. 

What’s more, the funds inside the annuity grow tax-deferred, meaning the total amount paid to the plaintiff over time is MORE than what they would have received via a lump sum.

Additionally, annuities provide non-tax benefits, such as the ability to create guaranteed payments for life, as well as the ability to ensure that the settlement funds won’t be depleted too quickly.

When working with plaintiffs, we can use the Plaintiff Recovery Trust AND a structured settlement annuity to dramatically increase what plaintiffs get to keep after taxes.

Your Next Step: Explore Your Tax Planning Solutions

We hope the answers to these ten frequently asked tax questions have been helpful. 

However, we know that settlement taxation is complex and can be overwhelming — and you likely have even more questions. Don’t worry — if you are getting a legal settlement and are worried about taxes, we are here to help you.

We offer a free, no-hassle 15-minute phone call for plaintiffs nationwide. Book your call today by clicking on the link.

On the call, we will determine if your settlement will be taxed. If so, my firm will prepare a free, customized tax savings analysis for you, showing exactly how much money you can save using each of these tax strategies. You won’t have to wonder if there’s something you could have done to avoid losing a large portion of your settlement to the IRS.

If you want a sneak peek at how much these tax planning strategies can save you, check out our proprietary, no-cost “Settlement Tax Calculator.” This calculator will estimate how much you’ll have to pay in taxes — AND, most importantly, it shows you how much more money you can keep by using one or both of the strategies mentioned in this article.

But please don’t wait to book a call since ALL of the tax planning strategies we shared in this article have to be set up before you receive your settlement. 

It’s sad to see someone pay way too much in taxes because they didn’t work with us to do some simple planning before settlement.

So, don’t wait! Book your free, no-hassle 15-minute call by clicking on the button below.

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