How Legal Settlements and Fees Are Taxed

How Legal Settlements and Fees Are Taxed

Let’s say you are involved in a serious auto accident. You may sue the other driver to pay for damages not covered by the insurance companies. Perhaps you even receive a large settlement. Are you on the hook for taxes on that lawsuit payout?

It depends. According to the IRS, monies received for personal injuries or illness are exempt from income taxes. If you receive a settlement for mental and emotional distress, that may also be tax exempt if it is directly related to a physical injury or illness.

Moreover, if you receive compensation specifically for vehicle damage resulting from a car accident, that’s not taxable either. This applies to both the cost of repairs as well as coverage for a rental vehicle while your car is being repaired.1

However, payouts received for punitive damages are subject to income taxes. Other settlements subject to federal income taxes include employment-related lawsuits, such as:2 

  • Wrongful discharge
  • Failure to honor contract obligations
  • Damages to compensate for economic loss (e.g., lost wages, business income and benefits)
  • Discrimination lawsuits related to age, race, gender, religion or disability

Also note that attorney and legal fees are generally not deductible on your federal tax return. This means you could be responsible for paying taxes on the full payout, including the portion that goes to attorney fees.3

Sometimes 100% of the proceeds from a legal settlement must be used to pay for bills and expenses based on the origin of the claim. Other times you may come out ahead, with excess money available to spend at your discretion. Once any tax liability is paid, consider your options for what to do with this money. One of them is to use it to help secure your financial future. If you’d like to learn ways to convert such a windfall to a guaranteed level of income during retirement, contact us to learn more.

Another type of settlement is the malpractice lawsuit. If a physician makes a mistake that results in physical pain, the proceeds from the medical malpractice lawsuit would not be taxable. However, what if your lawyer fails to file the lawsuit before the statute of limitations runs out? Then you may be able sue that lawyer for legal malpractice. Because that payout is directly related to the physical distress from the original claim, it would not be subject to taxes.

However, other types of legal malpractice lawsuit settlements, such as divorce, tax advice and real estate deals are reported as taxable income.4

Although this discussion gives you a general overview of the IRS rules regarding how legal fees and settlements are taxed, every case is different. It’s a good idea to consult with an experienced tax professional to help you assess if, and how much, of your compensatory payouts are subject to taxes.

Our firm is not affiliated with the U.S. government or any governmental agency. Guarantees and protections provided by annuities are backed by the financial strength and claims-paying ability of the issuing insurer. We are not permitted to offer, and no statement contained herein shall constitute, tax or legal advice. Individuals are encouraged to consult with a qualified professional before making any decisions about their personal situation. We are an independent firm helping individuals create retirement strategies using a variety of insurance products to custom suit their needs and objectives. This material is intended to provide general information to help you understand basic retirement income strategies and should not be construed as financial advice. The information contained in this material is believed to be reliable, but accuracy and completeness cannot be guaranteed; it is not intended to be used as the sole basis for financial decisions. If you are unable to access any of the news articles and sources through the links provided in this text, please contact us to request a copy of the desired reference.
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