Do You Have to Pay Taxes on a Settlement?

Are settlements taxable, and if so, how is the tax amount calculated?

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These are some important questions you should ask if you're involved in a lawsuit or other action that may result in you receiving funds from another party.

Seeing as the question involves laws and taxes, you probably won't be surprised that whether a lawsuit settlement is taxable depends on the situation. The money you receive from some settlements is taxable, while other settlement funds are not.

What Types of Settlements Are Not Taxable?

The details of the situation matter, so you should consult a tax professional to understand how to best manage and protect the funds you receive from a lawsuit. However, in general, you can expect to pay taxes on a settlement unless that settlement is related to a physical injury or illness.

One exception is if a settlement is related to a specific property loss. For example, if your insurance company pays for a new roof or reimburses you for the cost to repair your roof after hurricane damage, this isn't the type of settlement you'll be taxed on. The same is true when an insurance company settles with you to cover the cost of damage to a car following a collision.

You also typically won't pay taxes on settlements related to physical injury or illness, including compensation for medical expenses, lost wages and emotional distress related to physical injury. However, if you've paid the medical expenses in previous years and deducted those expenses from your taxable income on previous returns, you may have to report the compensation as income and pay taxes on it. This is to prevent people from duplicating a tax break.

Generally, you do have to pay taxes on settlements that aren't related to physical injury or illness. For example, if you sue for wrongful termination and win a settlement, you'll likely have to pay taxes on those funds.

Funds awarded as punitive damages in any settlement, even one related to a physical injury or illness, are taxable.

Note that all of the above information answers the question of whether a lawsuit settlement is taxable from a federal tax perspective. State tax laws and requirements can vary, so you should also ask whether you might have to pay state taxes on lawsuit settlement funds.

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Are You Charged Taxes on Legal Fees?

You aren't technically charged taxes on legal fees you pay. However, because of how settlement funds may be taxed, you might end up paying money on funds that you use for legal fees. That's because when a lawsuit settlement is taxable, you typically have to report the entire taxable amount as income. That's true whether you also then pay some of that amount in legal fees to your attorney.

How Do You Report a Settlement on Your Tax Returns?

The entity that paid the settlement, such as an insurance company, is typically required to provide a 1099 form detailing the amount of funds issued. You should receive this form in January the year after you receive any lawsuit settlement funds.

You'd then use this 1099-MISC form to report the income on your tax return documents as necessary. Typically, you can report this on your 1040 tax return form as "other income." However, you may want to consult a tax professional or accountant to help you understand what forms you may need. You might also follow the guidance in a tax preparation wizard in your tax software of choice, as these will typically complete the right forms if you enter all your 1099 information correctly.