Settlements can bring relief in the months following a traumatic accident, but they can also bring questions. A common question that arises from winning a claim is if taxes need to be paid on a settlement. It’s useful to understand the tax implications of your settlement to avoid any unexpected surprises that come with tax season. Learn more about what to expect in our breakdown.
Are Lawsuit Settlements Taxable?
Not all settlements are taxable. In many cases, the IRS will exempt the settlement you received from taxation because the amount is meant to compensate you for any losses that you suffered because of your injury. However, whether you pay taxes depends on the nature of the settlement:
Are Personal Injury Settlements Taxable?
Typically, any amount received for a personal injury, such as medical expenses or pain and suffering, is not taxable. This is because the IRS doesn’t consider compensatory damages as income.
Are Punitive Damages Taxable?
If you’ve also been awarded punitive damages on top of compensatory damages, this amount usually is taxable. Punitive damages are intended to punish the defendant rather than compensate, so the IRS views them as income on which you will likely owe taxes.
At the end of the day, the circumstances of each settlement vary, for example, if you took tax deductions for medical expenses in the time leading up to your settlement. It’s important to talk to a tax advisor or an attorney who is familiar with settlements to gain an understanding of your specific case.
When Do You Have to Pay Taxes on Settlement Money?
Understanding when taxes are due on your settlement can help you navigate financial responsibilities. There are key aspects to consider when it comes to the timing of taxes.
As mentioned earlier, compensatory damages are usually not taxable over any compensation that replaces income, such as lost wages or business income, which is treated like regular wages and is taxable. This must be reported on your Form 1040 when you file tax returns.
Interest is also a consideration when it comes to settlement. If your settlement is delayed, any interest that is accrued on the amount may also be taxable because the IRS treats interest as income.
Finally, if you choose to receive your settlement in installments (known as a structured settlement), the tax implications can vary. For example, the initial compensation may not be taxable, but interest earned on installments may be.
How to Report Settlement on Tax Return
If you find yourself in a situation where you do need to pay taxes on your settlement, reporting it correctly on your tax return is crucial. A tax advisor or personal injury lawyer can guide you through this process.
It’s important to clearly define the different components of your settlement. This means separating compensatory damages from punitive damages or any damages that fall under income. Taxable amounts are typically reported on Form 1040, while components such as lost wages could fall under ordinary income. Don’t hesitate to reach out to an expert if you’re feeling lost.
Remember to keep all documentation related to your settlement, including any agreements, correspondence, and payment records. This can help you down the line if the IRS requires proof of your settlement details.
How to Minimize Tax Liability
Paying required taxes is expected of anyone, but there are ways to potentially minimize the tax liability related to your settlement.
- If possible, negotiate the terms of your settlement. Ensure that compensatory damages are delineated from punitive damages or other taxable components. This paints a clear picture of what can and cannot be taxed.
- Consult a tax advisor or attorney who can provide personalized guidance and strategies tailored to your situation.
- If the settlement includes funds that can be put into retirement or health savings accounts, consider doing so to take advantage of tax benefits.
- Laws regarding taxes can change, so stay updated on regulations related to settlements to help you plan better.
Reach Out to a Team of Legal Experts for Guidance
While the general rule is that personal injury settlements are not taxable, there are always exceptions to consider. Understanding the nature of your settlement and working with professionals can help you navigate your tax obligations. The team at DM Injury Law has worked on countless cases and has over a century of combined experience. We’re not just the team that fights for justice but also the one that supports their clients from start to finish. Get in touch with us today if you need guidance. We offer free consultations and work tirelessly to ensure you get the compensation you deserve.