You might receive settlement funds, money paid to resolve a legal dispute, for a personal injury claim, workers’ compensation, or medical malpractice. While a settlement can help replace lost income and recover damages, it may also be taxable.
Here’s what you need to know to avoid a huge tax bill on your settlement money.
The type of settlement you receive can significantly impact how it’s taxed. The Internal Revenue Service (IRS) groups awards into three major categories:
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Actual damages: Also known as compensatory damages, actual damages involve a direct loss, often tangible, such as medical bills or lost wages.
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Emotional distress damages: These damages may also be compensatory, but usually include nonphysical or intangible harm, such as fear or anxiety.
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Punitive damages: These are typically awarded to punish malicious or fraudulent behavior, not necessarily to compensate the winning party.
Other details of your lawsuit will also factor into how the IRS treats the settlement, so you may want to work with an attorney or tax professional who can provide guidance.
The facts and circumstances of your case make a difference in whether the proceeds are taxed as income or are exempt.
According to IRC Section 104, a few main types of settlements are generally tax-free:
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Money received under workers’ compensation for personal injuries or sickness
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Damages received by lawsuit or agreement because of personal physical injuries or physical sickness
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Amounts paid for certain discrimination claims
The code defines damages as an amount received “through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution.”
It doesn’t matter if the compensation comes in a lump sum or periodic payments.
Diving in a bit deeper, if you receive a settlement for personal injuries from an accident, including lost wages, the amount is most likely not taxable.
If you receive a settlement for emotional distress, in order for it to be nontaxable, it must be directly because of personal physical injuries or sickness. You must also have not deducted actual medical expenses, medical costs, or medical bills related to the emotional distress on your taxes before. Basically, you can’t get the same tax benefit twice.
Read more: What is taxable income, and how can I reduce it?
Settlement money that replaces lost income or covers punitive damages is generally considered taxable by the IRS unless it meets an exception.
Common exceptions are physical injury, sickness, or wrongful death. These settlements are usually tax-free.
For example, money awarded for emotional distress stemming from a physical injury might be exempt from federal taxes — minus any previously deducted medical expenses. However, you could pay income tax on emotional distress money that’s not caused by an injury.
If your settlement is taxable, you’re also being taxed on any attorney fees —whether you pay them directly or they’re deducted from the award.
Learn more: Best tax deductions to claim this year
While you can’t avoid paying taxes on taxable settlement funds, you may be able to lower your bill if you plan ahead. It’s best to work with an attorney to understand what makes sense for your situation.
Remember, a settlement that compensates you for loss or damage from a physical injury may be tax-free. If you experienced a personal injury connected to your lawsuit, talk with your attorney to understand what documentation may be needed, such as confirmation from your healthcare provider.
If you negotiate your settlement to be a lump sum, the entirety of the taxable amount will be due for the tax year you receive it — potentially pushing you into a higher tax bracket. However, you can spread the money, and thus your tax liability, across years if you select a structured settlement annuity instead.
You may be able to offset some of the settlement tax by maxing out your retirement accounts. Although you’re still taxed up front, the money you contribute to a 401(k) or IRA is generally tax-deductible, lowering your taxable liability for the year. Just keep the contribution limits in mind: $24,500 for a 401(k) and $7,500 for an IRA for 2026.
Read more: Are IRAs tax-deductible? Here are the rules.
A PRT is designed to help you avoid the tax on attorney fees. When you set up an irrevocable trust, the trust becomes the owner of the settlement and is responsible for paying fees. You are the beneficiary, only paying taxes on what you receive from the trust. But you have to set up the trust before the settlement is paid.
QSFs are like a holding ground for settlement funds while you decide how to structure the payment. The money sits in the trust so you don’t have legal ownership, and because of that, you aren’t liable for any taxes until you receive a distribution.
Some settlement funds are taxable; some are not. It’s worth reporting all settlement income to the IRS to avoid potential penalties. Consider working with a tax professional who can dive into the specifics of your situation.
Settlement funds for physical injuries, sicknesses, or wrongful death are usually tax-free. However, they must be allocated in the agreement as such, so it’s important to work with an attorney beforehand to make sure the claim is set up appropriately.
You can choose a structured settlement annuity, which spreads your money over several years, to avoid owing taxes on a larger lump sum. This means you’re deferring taxes to future years, not avoiding them entirely. But you can potentially save money by paying taxes on a smaller amount.
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