How to Avoid Paying Taxes on Settlement Money: 5 Essential Tips

HomeSettlement Tax PlanningHow to Avoid Paying Taxes on Settlement Money: 5 Essential Tips

Last Updated: June 2024

Are you wondering how to avoid paying taxes on settlement money? 

What if we told you there are legal ways to avoid handing over a massive chunk of your settlement to the IRS? 

This article will discuss five little-known tax tips to maximize the amount you keep after your legal settlement. These outlined tips aren’t sketchy tax schemes. They’re entirely legal strategies we regularly use with plaintiffs nationwide. 

Most people have never heard of these strategies, but luckily, by the end of this article, you’ll understand how you can potentially double or even triple how much of your settlement money you get to keep after paying taxes, saving tens or hundreds of thousands of dollars in taxes, and avoid paying Uncle Sam the lion’s share of your settlement.

Before we dive in, know that the information contained in this article is intended for general informational purposes and is not intended to be tax advice.

First, an important question must be answered first before we can discuss tax strategy for your settlement.

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. 

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.
how to avoid paying taxes on settlement money annuity payouts

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. 

Tip 2: Use the Plaintiff Recovery Trust

The Tax Cuts and Jobs Act of 2017 created a very difficult situation for many settlement recipients. It changed the law so that a plaintiff’s ability to deduct legal fees depends on the type of case involved. 

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

We do have some good news, however. A tax planning tool called the Plaintiff Recovery Trust helps plaintiffs completely avoid the Plaintiff Double Tax Trap by allowing plaintiffs to only pay taxes on the amount they receive and not on the attorney’s fees in these cases.

In other words, it allows plaintiffs to avoid having to count their attorney’s legal fees as their own income. In practice, this means we can often double or even triple what plaintiffs get to keep after paying taxes just by using the Plaintiff Recovery Trust. 

Tip 3: Use Both an Annuity and the Plaintiff Recovery Trust

If your settlement is taxable and you cannot deduct legal fees due to the changes in the Tax Cuts and Jobs Act, then we can use both a structured settlement annuity with the Plaintiff Recovery Trust to get the greatest tax savings possible. Each strategy reduces taxes in a different way — and together, they multiply the total tax savings for the plaintiff. 

As a reminder, the Plaintiff Recovery Trust avoids the Plaintiff Double Tax Trap, allowing the plaintiff to exclude the amount paid to the attorneys for their fees from their own taxable income. This exclusion immediately reduces the plaintiff’s tax burden. However, the net amount paid to the plaintiff is still taxable. 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 use both the Plaintiff Recovery Trust and a structured settlement annuity, they benefit from the compounded tax savings of excluding 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 Tax 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. 

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 link 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, the Plaintiff Recovery Trust, 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. 

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