When Do Taxpayers Need to Set Aside Taxes for a Legal Settlement?

Many taxpayers will never need to evaluate the tax impact of a legal settlement. But for those who are seriously injured in a car crash, win a medical malpractice lawsuit, or are part of a nationwide class action product liability claim, knowing how a settlement award will be treated at tax time is crucial.

Failure to pay taxes on a taxable settlement could lead to an audit and hefty fines and fees down the road—and if this money has already been spent by the time the IRS comes calling, you could wind up in a serious debt situation. On the other hand, improperly classifying a non-taxable settlement as taxable could mean needlessly paying thousands of dollars in federal income taxes. 

What Settlement Monies Are Taxable?

Generally speaking, settlement dollars that are designed to compensate you for a loss aren’t taxed. For example, if your car sustains $20,000 in damages in an accident, receiving a $20,000 settlement just puts you back to where you were before the accident, and the IRS doesn’t believe this money should be taxed. The same principle holds for back wages or vacation pay in a wrongful termination lawsuit or medical bills and rehab costs in a medical malpractice lawsuit.

What Settlement Monies Are Tax-Exempt?

Where the analysis gets a bit fuzzier is when it comes to damages that are called “non-economic damages.” This includes pain and suffering, punitive damages, emotional damages, and other damages that go above and beyond the actual out-of-pocket costs you’ve sustained.

In most cases, and even under the changes the Tax Cuts and Jobs Act has brought to the U.S. Tax Code, these funds will be subject to federal income tax at your highest marginal tax rate. Your state may also assess taxes on non-economic damages, although some states treat these funds differently than regular income.