Are you wondering how to avoid paying taxes on settlement money? What if I told you there are legal ways to keep more of your settlement instead of handing over a massive chunk to the IRS?

In this guide, I’ll share five little-known tax tips to maximize the amount you keep after your legal settlement.

I’m a practicing attorney and a certified financial planner. I specialize in helping plaintiffs reduce the amount of taxes they pay on their settlements.

The five tips I’ll outline today are not shady tax schemes. These are completely legal strategies we use regularly with plaintiffs nationwide. However, most people have never heard of these methods.

You’ll understand how you could double or triple the amount of settlement money you get to keep after taxes.

For many of the clients I work with, these strategies help them save tens or even hundreds of thousands of dollars. So, if you’re expecting a settlement anytime soon, this could mean the difference between paying Uncle Sam the lion’s share or keeping more of what’s rightfully yours.

Legal Disclaimer

Before we dive in, please note:

The information in this guide is for general informational purposes only. It is not tax or legal advice. Consult a professional for your specific situation.

Do You Have to Pay Taxes on Settlement Money?

Before we get into tax-saving tips, we need to answer one crucial question:

Do you even have to pay taxes on your legal settlement?

Here’s what you need to know:

The default assumption of the IRS is that any money you receive from a legal settlement is taxable income.

The IRS follows Section 61 of the tax code, which states that almost all income is taxable—including money from legal settlements.

In other words, the IRS assumes that settlements are taxable unless proven otherwise.

The Origin of the Claim Rule

The main tax rule for legal settlements is called the “Origin of the Claim” Rule.

This rule states that whether your settlement is taxable depends on the reason you filed the lawsuit.

How Does This Work?

• If you sue your employer for lost wages, your settlement will be taxed as ordinary income.
• If you sue a business partner for lost profits from a joint venture, that settlement is also taxable as ordinary income.

The key is matching up the settlement payment with the original claim.

This means that both plaintiffs and defendants must pay close attention to the specific claims in the lawsuit to understand the tax implications of any settlement.

And here’s the catch:

The burden of proof falls on the plaintiff. If you want to claim that your settlement should be tax-free, you must prove to the IRS why it qualifies for an exemption.

What Types of Settlements Are Tax-Free?

The most common types of tax-free settlements are those received as compensation for personal physical injuries or physical sickness.

Section 104(a)(2) of the Internal Revenue Code

Under Section 104(a)(2), settlement money received on account of personal physical injuries or physical sickness is excluded from gross income—except for punitive damages.

In simple terms:

If you’re receiving a settlement due to a physical injury, you’re in luck—your settlement is completely tax-free.

What Types of Cases Qualify?

Typical cases that qualify for this tax-free exclusion include:

• – Car accidents
  – Slip and fall accidents
  – Medical malpractice
  – Other incidents causing physical injuries (e.g., cuts, bruises, broken bones, or worse)

If the origin of the claim involves an incident that caused personal physical injuries or sickness, Section 104(a)(2) allows you to exclude that money from taxation.

So, in short, if you’re receiving a personal injury settlement, you don’t owe the IRS anything—it’s 100% tax-free.

Bad News: Most Settlements Are Taxable

If you’re receiving nearly any other type of settlement, you’ll likely have to pay taxes on it.

The tips I cover in the rest of this guide are for people in the “I have to pay taxes” category. If your settlement will be taxed, you need these five essential tips to avoid paying more than necessary.

Tip 1: Use a Structured Settlement Annuity

One powerful way to reduce the taxes on your settlement is by using a structured settlement annuity.

How Does This Work?

Instead of receiving the entire settlement amount in one lump sum, all or a portion of the settlement funds can be allocated to purchase a structured settlement annuity. The annuity provider then makes payments to you on a set schedule.

The schedule can be customized to pay out over a few years or even for the rest of your life, depending on your needs and goals.

By spreading the settlement payments out over time, you receive the funds in smaller installments each year. This effectively allows the settlement income to be taxed at a lower marginal tax rate, compared to receiving the entire lump sum all at once in the year of settlement.

This strategic approach can save you thousands, if not tens of thousands of dollars in taxes over the course of the payout of that annuity—simply by keeping you in a lower tax bracket.

Beyond Tax Savings

Structured settlement annuities offer valuable benefits beyond tax savings. The annuity payments can provide a long-term income stream, with a guaranteed rate of return unaffected by market volatility.

A structured settlement annuity is a powerful tool to reduce taxes on legal settlements by lowering the plaintiff’s marginal tax rate. We’ve seen this work well for hundreds of plaintiffs nationwide, and it could help you too.

Tip 2: Use the Plaintiff Recovery Trust

If you can’t deduct legal fees, a Plaintiff Recovery Trust can be a great solution.

The Tax Cuts and Jobs Act of 2017 created a tricky situation for many settlement recipients. Specifically, the Act changed the law so that a plaintiff’s ability to deduct legal fees now depends on the type of case involved.

What Changed?

Some plaintiffs can still deduct attorney’s fees above the line on their tax returns and get a full deduction. Examples of case types that allow for an above-the-line deduction include:

• Unlawful discrimination cases
• Many types of employment cases
• Civil rights cases
• Whistleblower claims
• Lawsuits brought by a business

However, plaintiffs in many other common lawsuits can no longer deduct legal fees at all. These include:

• Defamation
• Legal or financial malpractice
• Bad faith claims
• Emotional distress cases
• Any case with punitive damages

The Impact of the Tax Cuts and Jobs Act

To understand the negative impact of the Tax Cuts and Jobs Act on these plaintiffs, let’s look at an example:

Let’s say there’s a $10 million settlement, and the contingency fee is 40%. This means $4 million goes to your attorney, and you—the plaintiff—receive $6 million.

You might think that you’d only pay tax on the $6 million you actually receive, right? Wrong.

Under the new tax law, the plaintiff pays taxes on the entire $10 million—even though they only receive $6 million.

This means you’re taxed on the full gross recovery, including the portion paid out to your attorneys in contingent fees.

The Double Tax Trap

Even worse, the attorney also pays tax on the $4 million they received, meaning the attorney fee portion is taxed twice.

This unfair outcome is known as the plaintiff double tax trap. But there’s some good news.

The Plaintiff Recovery Trust: A Game Changer

The Plaintiff Recovery Trust helps plaintiffs completely avoid the double tax trap. By using this trust, plaintiffs only pay taxes on the amount they actually receive, not on the attorney’s fees.

In other words, it prevents plaintiffs from having to count their attorney’s fees as part of their own taxable income.

What Does This Mean in Practice?

This approach can double or even triple the amount plaintiffs get to keep after paying taxes, simply by utilizing the Plaintiff Recovery Trust.

Tip 3: Use an Annuity and the Plaintiff Recovery Trust Together

If one planning tool is good, two tools are even better. If your settlement is taxable and you can’t deduct legal fees due to the Tax Cuts and Jobs Act, using both a structured settlement annuity and the Plaintiff Recovery Trust can provide the greatest tax savings possible.

Each strategy reduces taxes in a different way, and together, they multiply the total tax savings.

How Do They Work Together?

The Plaintiff Recovery Trust avoids the double tax trap, allowing the plaintiff to exclude attorney’s fees from their taxable income, which immediately reduces their tax burden. However, the net amount paid to the plaintiff is still taxable.

That’s where a structured settlement annuity comes into play. By spreading the income over time, a structured settlement annuity can lower the plaintiff’s marginal tax rate (as discussed in Tip 1), further reducing the tax burden.

When plaintiffs use both tools—the Plaintiff Recovery Trust and a structured settlement annuity—they benefit from compounded tax savings:

• Excluding attorney’s fees from taxable income
• Spreading income over time to lower the tax bracket

Many plaintiffs have been able to triple their after-tax recovery by using this powerful combination.

Tip 4: Maximize the Medical Expense Exclusion

An often overlooked strategy for reducing taxes is to allocate or assign a portion of the settlement to past and future medical expenses. Even if the legal claim isn’t based on personal injuries or sickness, plaintiffs may still allocate some settlement proceeds to medical expenses and make them tax-free.

This strategy can work even in cases involving emotional distress, employment disputes, or defamation.

How Does This Work in Practice?

For example, suppose an individual sues their employer for race-based workplace discrimination, leading to emotional distress. While emotional distress damages are typically taxable, the plaintiff could gather medical expense costs for physical symptoms like depression, insomnia, and anxiety caused by the distress.

With proper documentation, these medical expenses could be presented during settlement negotiations, potentially allocating a reasonable portion—say, 20% of the settlement—as non-taxable reimbursement for these eligible medical costs.

This allocation would reduce the overall tax burden for the plaintiff, as the amount allocated to medical costs is tax-free.

Similarly, in a defamation case, the victim could gather evidence of medical expenses for physical manifestations of emotional distress caused by reputational damage. Again, with proper documentation, a reasonable allocation could be made for tax-free medical expenses.

The Key Is Proof

The most important factor is to have proof of medical treatments for the physical issues—even if they were caused by something that isn’t physical.

Allocating Settlement Funds for Medical Expenses: Tax-Free Benefits

If the defendant agrees, you can allocate a portion of the settlement money for medical bills without having to pay taxes on that portion. Even if the settlement is for reasons that typically require tax payment, you can still get a portion tax-free.

Why Is This Helpful?

Allocating settlement funds to past and future medical expenses can save you money in taxes because the tax code states that reimbursement or payment for medical costs is tax-free and excluded from the plaintiff’s taxable income.

However, it’s essential to work with your attorney to ensure that this allocation is negotiated and included in the settlement agreement with the defendant. Without this allocation in the agreement, you won’t be able to take advantage of this tax-saving opportunity.

Tip 5: Allocate All Damages in the Settlement Agreement

In addition to allocating the settlement for medical expenses (as in Tip 4), allocating all damages in the settlement agreement can significantly reduce taxes.

Settlement Portion Allocation Example

For instance, a plaintiff can allocate part of the settlement as tax-free if it’s for personal physical injuries or sickness. Even in a job-related lawsuit, if there’s enough evidence, part of the settlement may be allocated as tax-free.

Moreover, the plaintiff can also allocate certain amounts as reimbursement for costs incurred due to the defendant’s actions. For example, if a plaintiff sues a financial advisor for giving bad investment advice, part of the settlement could be seen as repayment of the lost investment principal, which would not be taxed (as in Tip 4).

Additionally, a portion of the settlement could be allocated as reimbursement for medical costs, which would also be tax-exempt.

How to Allocate Damages in the Settlement

The settlement agreement doesn’t need to specify the exact dollar amounts for each type of damage. General language identifying categories such as personal physical injury or compensation for medical costs incurred might suffice. The key is to work with your attorney to allocate reasonable amounts to these tax-favored categories based on your case’s circumstances.

While this strategy requires the defendant’s consent, it’s definitely worth the effort. A customized allocation of damages in the settlement agreement can result in the plaintiff paying significantly less in taxes.

In conclusion, Paying taxes on settlement money can be devastating and significantly reduce your recovery. By planning ahead and using these five tips, you can legally reduce your tax bill and maximize the amount you keep after the settlement. But remember, it’s essential to get in touch before the settlement is finalized. Missing out on these strategies because of late planning can lead to overpaying in taxes.

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