Tax Rules Applicable to a Lawsuit Settlement

Is there a tax for money received for lawsuit settlement? This is a big question that needs a clear answer. Taxpayers receive deductions, savings plans, and tax credits to assist with necessary expenses, like higher education. Deductions reduce the tax that you have to pay by reducing your total taxable income. A savings plan is tax free until the money is withdrawn. A tax credit downgrades the sum of the taxes you have to pay for your income.

Lawsuit settlements are awards or compensations that you receive for involuntary separation. Since the settlement involves a large lump sum or large amounts of money, the litigant has to pay the government a huge sum representing taxes. However, there are rules that are applicable to these type of amounts.

  • Since the lump sum payment is not a payment for physical sickness or injuries, there is no tax exemption but appropriate taxes are imposed.
  • The lump sum payment may not be included in the income during the filing of income tax return.
  • The lump sum payment should not be taken in one go -  instead opt for annuity payment especially if the amount of the compensation is quite large. In annuity payments, regular monthly payments will be received and these are tax-free.
  • Sell your future lump sum payments by taking it in advance. If the money is not reinvested, no taxes will be imposed. The dividends or interests will only be taxable once the money is invested.
  • When you are receiving compensation, taxes for lawsuit settlement are not imposed.

Lawsuit settlement could be one’s fantasy or something that can be considered a chance because of the huge amount that will be paid. With the settlement one can dream of a grand vacation or a world tour. However, when taxes are mentioned, they can cause one to dread. Whatever amount is paid has its corresponding taxes that will be imposed by the government. If taxes are underpaid, there is a corresponding penalty for that.

To avoid penalty because of underpaid taxes, three safe protections are available:

  • Your tax due is less that $1,000
  • Pay your tax equal to your previous year’s legal responsibility
  • Pay 90 percent of the current year’s taxes

These tax rules applicable to a lawsuit settlement are important to every citizen in order to avoid paying huge taxes. Receiving compensation as a lawsuit settlement may not be taxable because the lawsuit may have been a result of a case where the petitioner is at the losing end. If the petitioner is the loser and the settlement money is just a compensation for the period where he should still be working, then taxes should not be imposed. However, that is not the case. Since the Internal Revenue Code is not applicable, it is up to the petitioner to make some financial tactics.

Pension settlement might be the best way of avoiding excessive taxes. With this line of attack, you sustain a stable monthly income because of the span of payments during the period.


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