How to Keep More of Your Settlement: Tax Tips for Lawsuit Winnings

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Settling a lawsuit can be a huge relief, but it’s important to remember that money you receive is taxable. Unless you take specific steps to avoid it, the IRS will take a significant chunk of your winnings. Let’s look at how to avoid paying taxes on your lawsuit settlement and keep more of that money for yourself! We’ll consider how the Feds tax settlements and look at some tips to reduce your tax bill and keep your money safe in the future! Let’s get started!

How Do Lawsuit Settlement Taxes Work?

Internal Revenue Code Section 61 states that all payments from any source are gross income unless a specific exemption exists. When you win a settlement, it can be challenging to know whether or not your award is taxable without research. Planning with an estate planning and assets protection attorney can make all the difference in keeping more of your money for your own use.

How much of the settlement you keep depends on whether your lawsuit has IRS exemptions.

Non-Taxable Lawsuit Settlements

  • Physical Injury, Disability, Disfigurement, or Sickness: The IRS does not look at settlements for physical harm or sickness where you’ve shown “observable bodily damage.” So, if you’ve suffered a physical injury, you likely won’t have to pay taxes on your settlement.
  • Emotional Distress: Emotional distress is usually taxed. However, if a physical injury caused emotional stress, then you may avoid taxes.
  • Specific Discrimination Claims: If you’ve filed a claim for discrimination that you did not base on lost wages, the settlement is likely not taxable.
  • Wrongful Death: If you settle a wrongful death suit, the proceeds are not considered taxable income to the beneficiaries.
  • Accident or Health Insurance Claims: Any compensation you receive for damage to your property is not taxable income. So, if a fire destroys your home and you receive a settlement from the insurance company, you won’t have to pay taxes on that money. If your health insurance owes you due to a lawsuit, that money is not income for you.
  • Workers’ compensation benefits: You will likely not need to pay any federal or state taxes, including Social Security and Medicare taxes, on workers’ compensation benefits.

Taxable Lawsuit Settlements

  • Punitive Damages: Punitive damages include those awarded where the defendant’s actions were particularly egregious. These damages are meant to punish wrongdoers and deter others from similar behavior. Punitive damages are generally taxable.
  • Lost Wages: The settlement is taxable income in a lost wages lawsuit. It is taxable because your income would have faced taxation had you earned it from the employer.
  • Medical Bills: Any portion of your settlement that you use as a reimbursement for your medical bills is taxable income. For example, “last year, Jo had unusually large medical bills and could take the itemized deduction. They got a $1,200 medical expense deduction as a result. In 2021, they got reimbursed $800 from their insurance company. Jo would report the lesser amount ($800) as a miscellaneous other income item.” (3)

How to Avoid Paying Taxes on a Lawsuit Settlement

So, how can you avoid paying taxes on your settlement? The best way to do it is to structure the settlement to fall into one of the above categories. However, if that’s not possible, you can also structure the payment so that you do not receive a lump sum.

Another strategy is to determine whether your award is a capital gain rather than an ordinary income. “Depending on the nature of your claim, you may be able to treat a portion of your settlement as capital gains. If you’ve sued over damage to your home or business factory, you may be able to classify the settlement as capital gains. Alternatively, your settlement might qualify as a recovery of tax basis, which is not counted as income.” (1)

Forbes states that planning before accepting a settlement is “even more important now with higher taxes on lawsuit settlements under the recently passed tax reform law.”

“Structuring” a settlement often means negotiating how you receive the money. A lump sum can bump you up into the next tax bracket causing a more significant percentage of your compensation to face higher tax bills. Negotiating with the other side before settling the case is crucial. You’ll likely want a yearly payout amount that will keep you in the tax bracket you are in now, not a lump sum on which you will pay maximum tax.

For example, let’s say you receive a taxable lump sum $200,000 settlement. If your litigating attorney takes 40%, you receive $120,000. That may feel okay until you get a 1099 in the mail and must report your $200,000 income on your tax return. You pay taxes on the whole amount, NOT on the amount after the attorney took their cut!

If the Feds take 25% of the $200,000, they get $50,000. At that point, your settlement is only $70,000, less than half of your original award!

If you’re unsure how to negotiate a structured settlement, talk to your asset protection attorney. They’ll be able to help you figure out how to avoid paying taxes on a lawsuit settlement. They will know the best way to structure your payments so that you can keep more of the money for yourself!

How to Keep A Settlement Safe

In the best of worlds, you will pay the least taxes while keeping your assets safe and protected in the future.

Whether you pay taxes on your settlement or not, you’ll want to keep your money safe in the future. To shield your assets from future loss, it’s crucial to consider a trust. A trust is a legal framework that can keep your assets safe from:

  • creditors
  • liens
  • civil lawsuits
  • divorce
  • probate court
  • public knowledge of your estate after death
  • bankruptcy
  • family disputes over your will
  • long term care costs
  • Medicaid Recovery of your estate and more

After paying taxes on your lawsuit settlement, if necessary, do more with your money by keeping it protected in the future. The key with trusts is setting them up long before you run into trouble.

For example, if you want to avoid long-term care costs specifically, you may place all of your assets into an irrevocable trust at least 5 years before you need long-term care. The trust gives you monthly income (below the maximum amount allowed for Medicaid eligibility.) 

If your home is worth less than a specific amount, you qualify for Medicaid to cover your long-term care costs in an assisted living or nursing home. You may even be eligible for home-help coverages!

We Can Help

If you’ve received a lawsuit award and want to keep it safe in the future, contact us at Vail Gardner Law. We can help you structure a settlement and keep your assets protected for the future. We specialize in estate planning, asset protection, and legacy planning. Give us a call today to set up a consultation!