Introduction
Receiving a settlement can be a financial relief, but many plaintiffs are shocked to discover they may owe significant taxes on their settlement money. The good news? There areways to legally reduce or even eliminate the tax burden on your settlement proceeds.
In this article, we'll break down whether settlement money is taxable, key tax-saving strategies, and common mistakes to avoid. By understanding the rules and leveraging the right tools, you can keep more of your hard-fought settlement.
Do You Get Taxed on Settlement Money?
The short answer is: it depends. Some types of settlement money are fully taxable, while others are tax-free. The IRS determines taxability based on what the settlement is compensating you for. If your settlement includes lost wages, punitive damages, or interest, those amounts are generally taxable. However, compensation for physical injuries or illness is often tax-free.
Before spending your settlement, it's crucial to understand what portion of your money is taxable and explore ways to minimize the tax hit.
Are Legal Settlements Taxable?
The default assumption of the IRS is that money you get from legal settlements is money you have to pay taxes on. Section 61 of the tax code states that the IRS will count all money you receive as taxable income (including money from a legal settlement) unless there’s an exception that applies. In other words, the IRS assumes that settlements are taxable unless proven otherwise.
The main tax rule for legal settlements is called the origin of the claim rule. This rule states that the taxes you pay on your settlement depend on the reason you started the lawsuit in the first place. In other words, whether you pay taxes and whether an exclusion applies is determined by what you are seeking recovery for in the lawsuit.
Here are some examples:
- Let’s say you sue your employer for lost wages and back pay. The settlement proceeds will be taxed as ordinary income — just like the wages would have been.
- Or, let’s say you sue a business partner for lost profits from a joint venture. Your settlement for those lost profits is taxable as ordinary income.
The key is matching up the settlement payment with the original claim asserted.
This origin of the claim rule means that both plaintiffs and defendants need to pay close attention to the specific claims involved in a lawsuit when evaluating the potential tax implications of the settlement.
The burden falls on the plaintiff to prove to the IRS that a legal settlement should be treated as tax-exempt income if they want to avoid paying taxes on the funds they receive. In short, if you receive money from a legal settlement and you believe you shouldn’t pay taxes on it, it’s your responsibility to prove to the IRS why it should be tax-free.
The most common types of tax-free settlements are those received as compensation for personal physical injuries or physical sickness. Settlements for personal physical injuries are excluded under section 104(a)(2) of the Internal Revenue Code, which states that “gross income does not include … the amount of any damages (other than punitive damages) received … on account of personal physical injuries or physical sickness.”
So, if you’re receiving a settlement because you are physically injured, here’s the great news:
Your settlement is completely tax-free!
Typical cases that qualify for this tax-free exclusion include:
- Car accidents
- Slip and fall accidents
- Medical malpractice
- Other incidents causing cuts, bruises, broken bones, or worse
If the origin of the claim involved some type of incident that caused personal physical injuries or physical sickness, section 104(a)(2) allows you to exclude the settlement money from taxation.
In short, if you’re getting a personal physical injury settlement, you’re in luck. It’s tax-free.
Here’s the bad news:
If you’re receiving nearly any other type of settlement, you’ll likely have to pay taxes.
The tips covered in the rest of this article are for the people in the “I have to pay taxes” category. So, if you’re receiving a settlement that will be taxed, you need these five essential tips to avoid paying more in taxes than you need to on your settlement recovery.
Key Strategies to Reduce Taxes on Settlement Money
There are several effective ways to legally reduce taxes on your settlement money:
Tip 1: Use a Structured Settlement Annuity
One powerful way to reduce the taxes on your settlement is to use a structured settlement annuity.
Here’s how a structured settlement annuity works:
- Instead of receiving the entire settlement amount in one lump sum payment, a portion of the settlement funds can be allocated to purchase a structured settlement annuity.
- The annuity provider (a highly-rated life insurance company) then makes payments to you, the plaintiff, on a set schedule.
- The annuity can be set up to pay out over a few years, several years, or can even be set up to pay for the rest of your life.
- The payment schedule can be customized at the time you set it up to meet your future needs and goals.
A structured settlement annuity is an effective tax-saving tool because by spreading the settlement payments into smaller installments each year, the money from the settlement will usually be taxed at a lower tax rate compared to receiving the entire lump sum all at once in the year of settlement.
This strategy can save you thousands, if not tens of thousands of dollars in taxes over the course of the payout of that annuity simply by keeping you in a lower tax bracket. We’ve seen this tool work well for hundreds of plaintiffs nationwide.
In addition to the tax benefits, structured settlement annuities also offer a long-term income stream with a guaranteed rate of return unaffected by market volatility.
Give us a call to learn how to get a structured settlement and determine if it's the right choice for your case.
Tip 2: Plan for Attorney Fee Taxes
The Tax Cuts and Jobs Act of 2017 created a very difficult situation for many settlement recipients by eliminating many miscellaneous itemized deductions, including legal-fee deductions in many taxable settlement cases. That problem did not simply disappear after 2025; the One Big Beautiful Bill Act, signed into law on July 4, 2025, made this issue even more important for plaintiffs whose cases do not qualify for an above-the-line attorney-fee deduction.
Some plaintiffs can still deduct attorney’s fees “above the line” on their tax returns. (An “above the line” deduction allows plaintiffs to get a full deduction for the amount they paid in attorney’s fees.)
Case types that allow for an “above the line” deduction include:
- Unlawful discrimination cases
- Many types of employment cases
- Civil rights cases
- Whistleblower claims
- Lawsuits brought by a business
However, plaintiffs in many other common lawsuits can no longer deduct legal fees at all. This can dramatically increase how much money is lost from the settlement to taxes.
Examples of cases where no deduction is allowed for amounts paid to attorneys as legal fees include:
- Defamation
- Legal or financial malpractice
- Bad faith claims
- Emotional distress cases
- Any case with punitive damages or pre- or post-judgment interest
To understand the negative impact that the Tax Cuts and Jobs Act can have on plaintiffs, let’s look at an example.
Total Settlement: $10
Attorney Contingency Fee of 40%: $4
Plaintiff’s Recovery: $6
You would think the plaintiff would only pay tax on the $6 they actually receive, right? Wrong. After the Tax Cuts and Jobs Act, the plaintiff pays tax on the full $10, even though the plaintiff only receives $6.
These unlucky plaintiffs pay tax on the entire gross recovery, including the portion paid out in contingent fees to their attorneys, with no offset or deduction for legal fees. The attorneys also pay tax on the $4 they receive, making the attorney fee portion of the case taxed twice.
This is an unfair outcome that we call the Plaintiff Double Tax Trap.
Greg's planning note: I have spent more than 20 years working with plaintiffs and attorneys to navigate settlement planning situations and reduce unnecessary tax burdens. This is one of the most painful tax problems I see: plaintiffs often do not realize the issue exists until the settlement is already too far along to fix. That is why this planning has to be done correctly — and it has to happen before the settlement documents are finalized.
We do have some good news, however. In the right cases, proactive tax planning arranged before settlement can reduce or avoid the Plaintiff Double Tax Trap, helping plaintiffs be taxed closer to the amount they actually receive.
In other words, the goal is to keep plaintiffs from being taxed on their attorney’s legal fees as if it were their own income. Done correctly, this planning can make a meaningful difference in what plaintiffs keep after paying taxes.
Tip 3: Combine an Annuity with Pre-Settlement Planning
If your settlement is taxable (see what settlements are taxable) and you cannot deduct legal fees due to the changes in the Tax Cuts and Jobs Act, then we can combine a structured settlement annuity with proactive pre-settlement planning for the greatest benefit.
As a reminder, proactive pre-settlement planning is aimed at the Plaintiff Double Tax Trap, with the goal of reducing the tax on amounts paid to attorneys for their fees. The net amount paid to the plaintiff is still taxable, and this is where a structured settlement annuity can provide further savings.
By using a structured settlement annuity, the plaintiff spreads out the taxable settlement over multiple years. As discussed in Tip 1, receiving payments over time lowers the plaintiff’s tax rate versus taking the net settlement amount all at once.
When plaintiffs combine pre-settlement planning with a structured settlement annuity, they can benefit from both reducing the tax on legal fees and spreading income over time to lower their tax bracket.
Many plaintiffs triple their after-tax net recovery using this powerful combination.
Note: If you’re wondering how using these tools might help you in your specific case, you can use our firm’s Settlement Calculator to estimate your own tax savings using these strategies.
Tip 4: Maximize the Medical Expense Exclusion
One often overlooked way for plaintiffs to reduce their taxes is to allocate or assign a portion of the settlement in the settlement agreement to past and future medical expenses.
Even when the origin of the legal claim is not based on personal physical injuries or sickness, plaintiffs may still be able to allocate some settlement proceeds to tax-free medical expenses.
This strategy can reduce taxes even in cases involving:
- Emotional distress
- Employment disputes
- Defamation
- And many more
For example, suppose an individual sues their employer for race-based workplace discrimination, which then results in emotional distress. While emotional distress damages themselves are typically taxable, the plaintiff could document the medical costs they incurred related to physical symptoms like depression, insomnia, and anxiety.
The plaintiff can present these medical expenses as part of settlement negotiations, and if successful, the settlement agreement could allocate a reasonable portion of the settlement (e.g., 20%) as a non-taxable reimbursement for these eligible medical costs. This allocation would then reduce the overall tax burden for the plaintiff because the amount allocated to the past and future medical costs is tax-free.
Similarly, in a defamation case, the victim could accumulate evidence of medical expenses for physical manifestations of emotional distress that resulted from the reputational damage they incurred. With proper documentation, a reasonable allocation to the settlement agreement could be made to these tax-free medical expenses.
The important thing is to have proof of medical treatments for the physical symptoms, even if they were caused by a physical injury or illness. If the defendant agrees, you can allocate the settlement money for medical bills without having to pay taxes on that portion. This way, even if you sued for reasons that will require you to pay taxes on the settlement, you can get a portion tax-free.
Why is this strategy helpful? Allocating settlement funds to past and future medical expenses can save on taxes because the tax code states that reimbursement or payment for medical costs is tax-free and excluded from the plaintiff’s income.
Note: You’ll need to work with your attorney to make sure this allocation is negotiated and included in the settlement agreement with the defendant. If the allocation isn’t in the settlement agreement, you won’t be able to take advantage of this tax-saving tip.
Tip 5: Allocate All Damages in the Settlement Agreement
In addition to allocating a portion of the settlement for reimbursement for medical expenses, which we covered in Tip 4, allocating the settlement to different types of damages can result in significant tax savings.
- A plaintiff may be able to allocate a part of the settlement money as resulting from a personal physical injury and would be able to receive those amounts tax-free.
- The plaintiff may be able to allocate a portion of the settlement as reimbursement for costs that they incurred because of the defendant’s wrongful actions.
For example, if a plaintiff sues a financial advisor for giving bad advice on investments, some of the settlement might be seen as repayment of the lost investment principal. This part wouldn’t be taxed.
In addition, as we discussed in Tip 4, some of the settlement could be allocated as reimbursement for medical costs, which would also be tax-exempt.
The settlement agreement does not need to specify exact dollar amounts for each type of damage. More general language identifying categories of damages, such as “for alleged personal physical injuries sustained” or “as compensation for medical costs incurred,” may suffice.
The key here is to work with your attorney to allocate reasonable amounts to tax-favored categories based on the circumstances of the case.
While this strategy requires the defendant’s consent, it is certainly worth the effort because a customized allocation of damages in the settlement agreement can result in the plaintiff paying significantly less in taxes.
Essential Tips for Filing Taxes on Settlement Proceeds
- Keep detailed records: Maintain all legal documents, settlement agreements, and correspondence with your attorney.
- Report correctly: Ensure you properly report taxable portions of the settlement on your tax return.
- Consult a professional: A CPA or tax advisor with experience in settlement taxation can help you navigate the complexities and maximize savings.
- Plan ahead: If taxes will be due, set aside the necessary funds to avoid surprises.
Mistakes to Avoid When Dealing with Settlement Taxes
- Failing to plan: Many plaintiffs spend their settlement before realizing the tax consequences.
- Ignoring legal fees: Attorney fees might still be considered taxable income, so it’s crucial to understand your obligations.
- Misclassifying settlement funds: Improper allocation can result in unnecessary tax liability.
- Not using tax-saving strategies: Missing out on structured settlements, trusts, or other tools can cost you thousands in unnecessary taxes.
The Road to Tax Savings: Your Next Steps
Paying a bunch of taxes after receiving money from a settlement can be devastating. Taxes can take a huge chunk of your recovery if you don’t plan ahead.
If you are getting a legal settlement and you’re worried about paying taxes, these five tips are legitimate, legal ways to reduce your tax bill and maximize the amount you keep.
We are here to help you keep as much of your settlement as possible. We offer a free, no-hassle 15-minute phone call for plaintiffs nationwide. Click the button below this article now to book a call.
On the call:
- We’ll chat about your case.
- Quickly assess if you need to pay taxes on your settlement.
- If you do have to pay taxes on your settlement, we’ll gather some basic information — and our firm will prepare a personalized tax savings analysis for you at no cost.
This customized analysis will show you exactly how much more you could keep using the strategies we discussed today: a structured settlement annuity, pre-settlement tax planning, or both.
In the meantime, check out our proprietary, no-cost Settlement Tax Calculator. This calculator will estimate how much you have to pay in taxes, and most importantly, it shows you how much more money you can keep by using many of the strategies outlined in this article.
Important Note: Please get in touch with our firm soon because all of these tax-saving strategies have to be set up before the settlement is finalized. If you wait too long, you won’t be able to take advantage of any of the strategies we discussed in this article.
It’s painful to witness someone overpaying in taxes just because they missed out on doing some straightforward planning with us prior to finalizing their settlement.
Don’t lose your settlement to taxes. Click the button below to book your free, no-hassle 15-minute phone call, and benefit from expert settlement tax planning.
Frequently Asked Questions (FAQs)
Do You Have to Pay Taxes on Medical Compensation From a Settlement?
If your medical expenses were not deducted on a prior tax return, medical compensation is generally tax-free. However, if you previously took deductions for medical expenses, that portion may be taxable.
Are Attorney Fees Deductible From Settlement Money?
In most cases, plaintiffs cannot deduct attorney fees from their taxable income. The full settlement amount, including the portion paid to the lawyer, is often subject to taxes. Certain exceptions apply, so professional tax guidance is recommended.
Can You Write Off Settlement-Related Expenses on Your Taxes?
It depends on the type of case. Business-related settlements or certain employment lawsuits may allow deductions, but personal settlements usually do not.
What Happens If You Don’t Report Settlement Income?
Failing to report taxable settlement income can result in IRS penalties, interest charges, and potential legal trouble. If you’re unsure about tax obligations, consulting a tax professional is essential.
Conclusion
Understanding the tax implications of your settlement is critical to maximizing what you keep. Without proper planning, you could end up paying thousands—or even tens of thousands—in unnecessary taxes.
At Amicus Settlement Planners, we specialize in helping plaintiffs navigate these complex tax issues. Our team can guide you through structured settlements, trust options, and other tax-saving strategies to ensure you get the most from your settlement.
Schedule a free consultation with Amicus Settlement Planners today to explore how you can legally minimize taxes on your settlement money. Please get in touch with our firm soon because all of these tax-saving strategies have to be set up before the settlement is finalized. If you wait too long, you won’t be able to take advantage of any of the strategies we discussed in this article.
Greg's planning note: After more than two decades of helping plaintiffs structure settlement recoveries, I can tell you that timing is often the difference between a strong after-tax outcome and a painful missed opportunity. It’s painful to witness someone overpaying in taxes just because they missed out on doing some straightforward planning with us prior to finalizing their settlement.
