How Much Tax Do You Pay on Lawsuit Settlements?

PUBLISHED ON: May 3, 2024

You’re working with a personal injury lawyer toward a settlement in your case when a question crosses your mind: do you have to pay taxes on a lawsuit settlement? It’s important to understand your tax obligations so you know how much of the settlement you get to keep and how much of it goes to Uncle Sam.

Lawsuit settlement money in Texas

Texas State Taxes on Lawsuit Settlements

Texas is one of only nine states that don’t have their own income tax. This means that if you receive a lawsuit settlement in Texas, you won’t have to worry about state taxes affecting your settlement money.

The Federal “Actual Damages” Rule

At the federal level, the IRS has established clear guidelines on what parts of a settlement are taxed and what parts are exempt. The core principle here is the “actual damages” rule, which determines taxability based on the nature of the compensation. Here’s how it breaks down:

  • Medical expenses, including hospital bills, physical therapy, and rehabilitation,related to treating physical injuries or sicknesses are non-taxable if you took no prior itemized medical expense deductions related to the injury or sickness in prior years. If you took a deduction in the past, the portion corresponding to previously deducted medical expenses is taxable proportionate to the tax benefit received.
  • Pain and suffering, lost quality of life, emotional distress, and mental anguish are non-taxable if they relate directly to a physical injury or sickness. If not related, the taxable amount is reduced by the amount of non-deducted medical expenses and non-beneficial prior deductions.
  • Lost wages related to employment are taxed as wages. Lost business-related profits are taxed as self-employment income.
  • Property loss is non-taxable if the settlement does not exceed the property’s adjusted basis. Any excess over the basis is taxable.
  • Punitive damages are taxable as they are intended to punish the defendant rather than compensate the plaintiff for a loss.
  • Interest that accumulates if the insurer doesn’t pay out the settlement immediately is taxable.

Tips for Preparing Federal Settlement Taxes

Preparing your tax returns after receiving a settlement involves careful planning to ensure compliance while maximizing your take-home amount. Here are a few tips:

  • Keep detailed records of all awarded amounts, medical bills, and other paperwork related to your settlement.
  • Do not list actual damages on your tax return.
  • List non-actual damages as “Other Income” on Form 1040 Schedule 1.
  • Report interest from a settlement or court award as “Interest Income” on Form 1040.
  • Make estimated payments if you expect your total tax bill to be $1,000 or more after subtracting credits and withholdings to avoid penalties using Form 1040-ES.
  • Consult a tax professional or lawyer to help you take all the proper steps.

Contact Nava Law Group

Understanding how the IRS taxes lawsuit settlements can be confusing. Nava Law Group can help you avoid unnecessary penalties and keep more money in your pocket. We have successfully recovered over $1 billion in compensation, serving more than 40,000 injury victims and their families. So, if you’re dealing with a personal injury and need expert guidance pursuing a settlement, call us at 713.661.9900 for a free consultation at one of our offices in Houston, Bellaire, Edinburg, or Austin, TX.

Schedule A Free Consultation