How to Pay Taxes When You Win a Cash Settlement

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There's no tax on a settlement for physical injury or medical bills.
There's no tax on a settlement for physical injury or medical bills. (Image: 4774344sean/iStock/Getty Images)

If you win a cash settlement in a lawsuit, there's a good chance you'll have to pay tax on it. The amount of taxes you owe, if any, depends in part on the category of your victory. Punitive damages, for example, are taxable income, reported as "other income" on line 21 of Internal Revenue Service Form 1040. Interest on the settlement goes down as interest income on line 8A. Other types of payment get a different treatment.

Physical Injury

Settlements for physical sickness or injury are not taxable. Neither are any payments for emotional distress resulting from the injury. However, if you win an award for any unrelated emotional pain, that money is taxable. If you claimed a medical write-off in previous years for expenses related to the injury, that part of your settlements becomes taxable. For example, a $10,000 medical deduction for your injury last year may require you report $10,000 of your settlement as taxable income.

Lost Money

Some settlements -- over discrimination in firing, for example -- include payments for lost wages, the money you would have earned if you'd been treated fairly. Any part of the settlement that covers lost wages or self-employment income is taxable, just as if you had earned the money. Along with income tax, you also pay Social Security and Medicare tax on the money. If your financial loss was due to property damage -- a ruined car, say -- settlements that compensate you for the loss aren't taxable.

Legal Fees

If the settlement includes money for your legal fees, that money may be taxable. If the fees are combined with back wages in a lump payment, the IRS says the entire amount is taxed like wages. If the fees are allocated to a separate part of the settlement, they're considered regular income. In an unlawful discrimination case, if you pay your own attorney fees, they may be deductible from the settlement. If the settlement isn't taxable -- for example, it's for a physical injury -- then a payment for legal fees is also tax free.

Reporting Income

The written settlement should tell you how to break down your award -- which part is for physical injury, how much is for punitive damages and so on. Use that to figure out how to report your income. Treat lost wages as wages, while lost self-employment income is added to your business income on line 12 of the 1040. Most other taxable payments are considered "other income." If part of the settlement isn't taxable, you don't report it on the 1040. If, say, 60 percent of the settlement is for physical injury, you can usually allocate 60 percent of the legal fees to that category, making them nontaxable.

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