Representation in civil lawsuits doesn’t come cheap. In the best-case scenario, you’ll be awarded money at the end of either a trial or a settlement process. But before you blow your settlement, keep in mind that it may be taxable income in the eyes of the IRS. Here’s what you should know about taxes on lawsuit settlements. A financial advisor can help you optimize a tax strategy for your lawsuit settlement.
A financial advisor may be able to help. Match with an advisor serving your area today.
If you get a settlement from a lawsuit it could be for one of a few reasons. You could receive damages in recognition of a physical injury, damages from a non-physical injury or punitive damages stemming from the defendant’s conduct. In the tax year that you receive your settlement, it might be a good idea to hire a tax accountant, even if you usually do your taxes yourself online. The IRS rules around which parts of a lawsuit settlement are taxable can get complicated.
The tax liability for recipients of lawsuit settlements depends on the type of settlement. In general, damages from a physical injury are not considered taxable income. However, if you’ve already deducted, say, your medical expenses from your injury, your damages will be taxable. You can’t get the same tax break twice.
In some cases, you may get damages for physical injury stemming from a non-physical suit. For example, if you win a libel suit and get damages for the doctors you saw about your stress-induced headaches after being libeled, the damages for those medical expenses are not taxable, assuming you haven’t already deducted them from your taxes.
Although emotional distress damages are generally taxable, an exception arises if the emotional distress stems from a physical injury or manifests in physical symptoms for which you seek treatment.
In most cases, punitive damages are taxable, as are back pay and interest on unpaid money. Damages you receive for emotional distress are also taxable, with the exceptions above as well. And here’s the kicker: you owe taxes on the full amount that you receive, including any attorney fees.
That’s right – even if you don’t take the money home it’s still part of your award and subject to taxes. And if the opposing side has to pay your attorney’s fee, that fee is taxable income too. Depending on the type of suit you file, you may be able to deduct your attorney fees.
You might need a tax accountant or tax lawyer to help you navigate the post-settlement process and stay on the right side of the law. However, you don’t have to be an expert to see that it’s wise to set aside part of your settlement to cover the tax bill. Receiving a settlement could bump you up to a higher tax bracket and leave you with a much bigger April bill than you usually get.
Photo credit: ©iStock.com/stevecoleimages, ©iStock.com/Avosb, ©iStock.com/piranka
Amelia JosephsonAmelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
Read More About Taxes
More from SmartAsset
SmartAsset Advisors, LLC ("SmartAsset"), a wholly owned subsidiary of Financial Insight Technology, is registered with the U.S. Securities and Exchange Commission as an investment adviser. SmartAsset's services are limited to referring users to third party advisers registered or chartered as fiduciaries ("Adviser(s)") with a regulatory body in the United States that have elected to participate in our matching platform based on information gathered from users through our online questionnaire. SmartAsset receives compensation from Advisers for our services. SmartAsset does not review the ongoing performance of any Adviser, participate in the management of any user's account by an Adviser or provide advice regarding specific investments.
We do not manage client funds or hold custody of assets, we help users connect with relevant financial advisors.
This is not an offer to buy or sell any security or interest. All investing involves risk, including loss of principal. Working with an adviser may come with potential downsides such as payment of fees (which will reduce returns). There are no guarantees that working with an adviser will yield positive returns. The existence of a fiduciary duty does not prevent the rise of potential conflicts of interest.
