Receiving a legal settlement can feel like a financial windfall, but the excitement can quickly turn to concern when you realize taxes might take a significant bite. Many people are unaware that settlement money isn’t always tax-free, and understanding how to navigate these rules is crucial to maximizing your recovery.
Are you wondering how to keep more of your settlement money out of the hands of the IRS? It’s a common worry, and fortunately, there are legitimate strategies to minimize your tax burden.
This guide, brought to you by the financial experts at money-central.com, dives into five key tax tips that are not loopholes or risky schemes, but sound, legal approaches used by plaintiffs across the country. These strategies can potentially double or even triple the amount of your settlement you get to keep after taxes, potentially saving you thousands or even tens of thousands of dollars.
Before we get started, please remember that this information is for educational purposes only and should not be considered tax advice. Consult with a qualified tax professional for advice tailored to your specific situation.
Let’s address a fundamental question:
Do You Have to Pay Taxes on Legal Settlement Money?
The IRS operates under the assumption that all income, including legal settlements, is taxable unless a specific exemption applies. According to Section 61 of the U.S. Tax Code, any money you receive is considered taxable income unless proven otherwise. This means the default position is that your settlement is taxable.
The core principle governing settlement taxation is the origin of the claim rule. This rule dictates that the taxability of your settlement hinges on the nature of the lawsuit itself – what were you seeking compensation for? The IRS will look at the underlying reason for your legal action to determine if the settlement is taxable.
Let’s illustrate with a couple of examples:
- Imagine you sued your former employer for unpaid wages. Any settlement you receive to cover those lost wages will be taxed as ordinary income, just as your regular paycheck would have been.
- Consider a scenario where you sued a business partner for lost profits from a joint venture. Settlement funds representing those lost profits are also considered taxable as ordinary income.
The critical takeaway is that the IRS “matches” the settlement payment to the original claim. Both plaintiffs and defendants must carefully consider the claims within a lawsuit to understand the potential tax implications of any settlement.
The onus is on you, the plaintiff, to demonstrate to the IRS that your settlement qualifies for tax-exempt status if you wish to avoid taxation. Essentially, if you believe your settlement should be tax-free, you must prove to the IRS why it should be excluded from taxable income.
The most prevalent type of tax-free settlement involves compensation for personal physical injuries or physical sickness. Section 104(a)(2) of the Internal Revenue Code explicitly excludes from gross income “the amount of any damages (other than punitive damages) received… on account of personal physical injuries or physical sickness.”
Therefore, if your settlement stems from a physical injury, there’s good news:
Your settlement is generally tax-free!
Common cases falling under this tax-free category include:
- Car accidents
- Slip and fall incidents
- Medical malpractice cases
- Accidents resulting in physical harm like cuts, bruises, or broken bones
If your claim originated from an event causing personal physical injury or sickness, Section 104(a)(2) allows you to exclude the settlement proceeds from taxation. In short, a personal physical injury settlement is typically tax-free.
However, the less favorable news is:
For almost all other types of settlements, you will likely owe taxes.
The following tips are designed for those who fall into this “taxable settlement” category. If your settlement will be taxed, these five essential strategies can help you minimize your tax liability and retain more of your recovery.
Tip 1: Utilize a Structured Settlement Annuity
One effective method to reduce taxes on your settlement is through a structured settlement annuity.
Here’s how it works:
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Instead of receiving your entire settlement as a single lump sum, a portion can be used to purchase a structured settlement annuity.
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An annuity provider, typically a highly-rated life insurance company, then issues payments to you, the plaintiff, according to a predetermined schedule.
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The payout schedule can be tailored to your needs, spanning a few years, many years, or even your entire lifetime.
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The payment schedule is customized at the outset to align with your financial goals and future needs.
A structured settlement annuity is a powerful tax-saving tool because by distributing settlement payments over time in smaller installments, the income is often taxed at a lower rate compared to receiving the entire amount at once in a single tax year.
This strategy can potentially save you thousands, even tens of thousands of dollars in taxes over the annuity’s payout period, simply by keeping you in a lower tax bracket. This approach has proven successful for numerous plaintiffs nationwide.
Beyond tax advantages, structured settlement annuities provide a consistent, long-term income stream with a guaranteed rate of return, shielded from market fluctuations.
To explore if a structured settlement annuity is right for your situation, consult with a financial advisor specializing in settlement planning.
Tip 2: Implement a Plaintiff Recovery Trust
The Tax Cuts and Jobs Act of 2017 brought about a significant change, creating a challenging tax situation for many settlement recipients. It altered the rules regarding the deductibility of legal fees, making it dependent on the type of case.
Some plaintiffs can still deduct attorney’s fees “above the line” on their tax returns. This “above the line” deduction is advantageous because it allows plaintiffs to fully deduct the legal fees they paid.
Case types generally eligible for “above the line” legal fee deductions include:
- Cases of unlawful discrimination
- Many employment-related lawsuits
- Civil rights cases
- Whistleblower claims
- Lawsuits initiated by businesses
However, plaintiffs involved in many other common types of lawsuits are now unable to deduct legal fees at all. This can substantially increase the amount of settlement money lost to taxes.
Examples of cases where legal fee deductions are often disallowed include:
- Defamation cases
- Legal or financial malpractice claims
- Bad faith claims
- Emotional distress cases
- Cases involving punitive damages or pre- or post-judgment interest
To understand the detrimental impact of the Tax Cuts and Jobs Act, consider this example:
Imagine a $100,000 Settlement:
Attorney Contingency Fee (40%): $40,000
Plaintiff’s Net Recovery: $60,000
One might assume the plaintiff would only be taxed on the $60,000 they actually receive, right? Unfortunately, that’s incorrect in many cases. After the Tax Cuts and Jobs Act, the plaintiff may be taxed on the full $100,000, even though they only pocketed $60,000.
These plaintiffs are unfairly taxed on the entire gross settlement amount, including the portion paid to their attorneys as contingent fees, without any deduction or offset for these legal expenses. Furthermore, the attorneys also pay taxes on their $40,000 fee income, resulting in double taxation on the attorney fee portion of the case.
This unjust outcome is known as the Plaintiff Double Tax Trap.
The good news is that a tax planning tool called the Plaintiff Recovery Trust can help plaintiffs completely avoid this double tax trap. It enables plaintiffs to be taxed only on the net amount they receive, excluding attorney’s fees in these situations.
Essentially, it prevents plaintiffs from having to count their attorney’s legal fees as their personal income. In practice, utilizing a Plaintiff Recovery Trust can often double or even triple the amount plaintiffs keep after taxes.
Tip 3: Combine Annuities and Plaintiff Recovery Trusts for Maximum Savings
If your settlement is taxable and you cannot deduct legal fees due to the Tax Cuts and Jobs Act, combining a structured settlement annuity with a Plaintiff Recovery Trust can yield the greatest tax savings. These strategies work in distinct ways, and when used together, they amplify the overall tax benefits for the plaintiff.
As mentioned, the Plaintiff Recovery Trust circumvents the Plaintiff Double Tax Trap, allowing plaintiffs to exclude attorney’s fees from their taxable income. This immediately reduces the plaintiff’s tax liability. However, the net amount the plaintiff receives is still taxable. This is where a structured settlement annuity provides further tax advantages.
By using a structured settlement annuity, the taxable portion of the settlement is spread out over several years. As discussed in Tip 1, receiving payments over time can lower the plaintiff’s overall tax rate compared to receiving the entire net settlement at once.
When plaintiffs utilize both the Plaintiff Recovery Trust and a structured settlement annuity, they benefit from the combined tax advantages of excluding legal fees and spreading income over time to potentially fall into lower tax brackets.
Many plaintiffs have tripled their after-tax net recovery by strategically combining these powerful tools.
Note: To understand how these strategies might apply to your specific case, you can utilize online settlement tax calculators to estimate potential tax savings.
Tip 4: Maximize the Medical Expense Exclusion
An often-overlooked tax-saving opportunity is allocating a portion of the settlement in the settlement agreement to past and future medical expenses.
Even when the origin of the legal claim isn’t rooted in personal physical injuries or sickness, plaintiffs may still be able to designate some settlement funds for tax-free medical expenses.
This strategy can reduce taxes even in cases involving:
- Emotional distress
- Employment disputes
- Defamation
- And many other types of claims
For example, consider an employee who sues for race-based workplace discrimination, resulting in emotional distress. While emotional distress damages are typically taxable, the plaintiff might have incurred medical expenses for physical symptoms like depression, insomnia, or anxiety stemming from the discrimination.
During settlement negotiations, the plaintiff can present these documented medical costs. If successful, the settlement agreement can allocate a reasonable portion of the settlement (e.g., 20%) as tax-free reimbursement for these eligible medical expenses. This allocation reduces the plaintiff’s overall tax burden because the amount allocated to past and future medical costs is tax-free.
Similarly, in a defamation case, a victim could gather evidence of medical expenses for physical health issues resulting from the emotional distress caused by reputational damage. With proper documentation, a reasonable allocation within the settlement agreement can be made for these tax-free medical expenses.
The crucial element is having evidence of medical treatments for physical symptoms, regardless of whether the initial claim was for physical injury or illness. If the defendant agrees, allocating settlement money for medical bills becomes a tax-free benefit. Even in cases where the primary lawsuit is for taxable damages, this strategy allows for a tax-free portion.
Why is this strategy beneficial? The tax code excludes reimbursements or payments for medical costs from a plaintiff’s income, making them tax-free. Therefore, allocating settlement funds to these expenses results in tax savings.
Important: You must collaborate with your attorney to ensure this medical expense allocation is negotiated and explicitly included in the settlement agreement with the defendant. Without this specific allocation in the agreement, you cannot utilize this tax-saving tip.
Tip 5: Strategically Allocate All Damages in the Settlement Agreement
Beyond medical expense allocation (Tip 4), carefully allocating the settlement across different types of damages can lead to significant tax advantages.
- A portion of the settlement can be allocated as compensation for personal physical injury, making that amount tax-free.
- Another part can be designated as reimbursement for costs directly incurred due to the defendant’s wrongful actions.
For example, if a plaintiff sues a financial advisor for negligent investment advice, a portion of the settlement might be considered repayment of the lost investment principal. This portion would likely not be taxed as income.
Furthermore, as discussed in Tip 4, a segment of the settlement could be allocated to cover medical expenses, also enjoying tax-exempt status.
The settlement agreement doesn’t require precise dollar amounts for each damage category. More general language identifying categories, such as “for alleged personal physical injuries sustained” or “as compensation for medical costs incurred,” can be sufficient.
The key is to work closely with your attorney to allocate reasonable amounts to tax-favored categories, based on the specifics of your case.
While this strategy necessitates the defendant’s agreement, it’s a worthwhile effort because a well-structured damage allocation within the settlement agreement can substantially reduce the plaintiff’s overall tax liability.
Paving the Way to Tax Savings: Your Next Steps
Facing a large tax bill after receiving settlement money can be disheartening. Without proper planning, taxes can consume a significant portion of your recovery.
If you are anticipating a legal settlement and are concerned about taxes, these five tips provide legitimate, legal avenues to reduce your tax burden and maximize the amount you keep.
We at money-central.com are dedicated to helping you retain as much of your settlement as possible. We offer a complimentary, no-obligation consultation to plaintiffs nationwide. Contact us today to schedule a call.
During your consultation:
- We’ll discuss your case to understand your situation.
- We’ll quickly assess whether your settlement will likely be taxable.
- If taxes are a concern, we’ll gather some basic information and prepare a personalized tax savings analysis for you – completely free of charge.
This tailored analysis will demonstrate precisely how much more of your settlement you could retain by utilizing strategies like structured settlement annuities, Plaintiff Recovery Trusts, or a combination of both.
In the meantime, explore our free online Settlement Tax Calculator. This tool can estimate your potential tax liability and, more importantly, illustrate the potential savings achievable by implementing the strategies discussed in this article.
Crucial Reminder: Please reach out to us promptly because these tax-saving strategies must be established before your settlement is finalized. Delaying action may prevent you from taking advantage of these valuable tax minimization techniques.
It’s unfortunate to see individuals overpay taxes simply due to a lack of proactive planning prior to finalizing their settlement.
Don’t let taxes unnecessarily reduce your settlement recovery. Contact us now to schedule your free, no-obligation consultation and benefit from expert settlement tax planning.
