The information below is for educational purposes only and it should not be taken as legal or tax advice. Consult with a licensed tax specialist or tax attorney before making any decision based on this information.
If you’re a U.S. citizen who recently received proceeds from a legal settlement, be aware of any possible tax requirements on lump sums, as these can directly affect your retirement and estate planning. Depending on the type of compensation received, and if it involved certain kinds of claims and attorneys’ fees, the IRS may count a settlement as income and tax it accordingly.
Physical illness or injury
The IRS doesn’t count settlements based on physical illness or personal injury as income, as long as you did not take an itemized deduction that year on your income tax. If you receive a settlement for medical expenses, but you deducted any amount in prior years as a tax benefit, then this part of the settlement counts as income.
Emotional distress or mental anguish
Settlements for emotional distress or mental anguish have the same rules for physical illness or injury, with one exception: You must include any proceeds for this purpose that did not originate from personal injury or illness in your income. In other words, this is any additional proceeds paid out for mental anguish not directly caused by the original injury.
The IRS holds that such proceeds are additional income not related to the settlement and must be taken into consideration separately for both legal and tax purposes.
Lost wages or profits
If you are unfairly dismissed from employment, you may receive a settlement for lost wages, benefits, severance, back pay, or other income. According to the IRS, this settlement is considered regular income, even though severance pay is often tax free in Israel. This kind of settlement is also subject to the Social Security wage base table and Medicare tax rates for the year in which you were paid. Reporting legal compensation for lost wages is similar to reporting income for regular pay when you were employed.
Interest on any settlement, as with any income, is taxable and should be reported as “interest income.”
Punitive damages are taxable and therefore must be reported, even if received in a settlement for personal or physical illness or injuries.
Make estimated tax payments early if you know you’re going to owe at least $1,000 in income tax from having to report receipt of a legal settlement amount.
Taxation on settlements is complicated. Remember to speak with a qualified tax advisor to get advice since this article is just for general information. We help people manage their U.S. investment account, not file their tax returns.
How to handle the money when it comes in
We’ve recently dealt with many people who were receiving a lump sum settlement from a lawsuit. Because of difficulties of American citizens investing with Israeli banks these clients were happy to be able to open an account in the United States. With simple instructions, the clients then told the law firm where to wire the money, and the whole process went smoothly.
Unfortunately, dealing with settlements often has stresses, both practical and emotional. It’s important to understand your tax situation as well as work with an investment firm that understands your specific needs.