After a taxing experience, being awarded a settlement from a personal injury lawsuit can be a welcome relief. But it’s crucial to consider potential tax implications before spending the entirety of your settlement. It’s not uncommon for individuals to be caught off guard, realizing too late that their legal settlements could be considered taxable income by the IRS.
However, by taking proactive steps and getting guidance from a personal injury lawyer, you can potentially minimize or even avoid certain taxes on your settlement funds. This article provides insights into settlement taxation in Georgia and tips to safeguard your funds, especially if you’re working with a firm like Sawyer Injury Law in Atlanta.
Are All Legal Settlements Taxable in Georgia?
While many believe that settlements are automatically exempt from taxes, the reality is a bit more nuanced. For instance, in Georgia, most personal injury settlements, often secured with the help of a personal injury attorney, are non-taxable. This covers compensation for physical harm, medical expenses, lost wages from injuries, and pain and suffering. However, it’s important to note that legal fees might be taxable if deducted from the settlement amount.
Based on the IRS tax code, whether your settlement is taxable can be influenced by:
- The nature of your claim.
- The classification of your settlement.
- The types of damages awarded.
Key distinctions in the taxability of lawsuit settlements in Georgia include:
Settlements for Physical Injuries are Generally Non-Taxable
If your settlement was due to physical injury or sickness, the full amount is likely tax-free. This includes compensation for medical expenses, pain and suffering, emotional distress, loss of consortium, and other damages linked to physical harm.
Punitive damages related to a physical injury are also non-taxable.
Settlements for Non-Physical Claims are Fully Taxable
On the other hand, settlements for non-physical claims are generally 100% taxable. These include settlements for:
- Employment discrimination
- Wrongful termination
- Sexual harassment
- Breach of contract
Any punitive damages awarded in these types of cases are also fully taxable.
Mixed Settlements Require Allocation
Many settlements resolve a combination of physical and non-physical claims. For instance, a settlement might include compensation for medical bills, emotional distress, lost wages, and damage to reputation from libel.
In these cases, it’s critical to allocate the settlement proceeds across the different types of damages. This allows you to exclude the portion related to physical injury from taxation.
Proper allocation requires working closely with your attorney and tax professional. Keeping detailed records of damages claimed can also help support your tax position.
How to Reduce Paying Taxes on a Lawsuit Settlement
Fortunately, there are several strategies available to help minimize taxes on your settlement depending on your specific situation:
Claim the Recovery of Tax Basis
If your settlement includes compensation for lost wages or income, you may be able to deduct the tax basis you originally paid on that income.
For example, if you recover $50,000 in lost income and already paid 25% in taxes when you earned it, your tax basis would be $12,500. By deducting this amount, you only pay taxes on the remaining $37,500.
Structure the Settlement as Capital Gains
Another option is to try structuring all or part of the settlement as capital gains income. Long-term capital gains are taxed at much lower rates than ordinary income.
This generally requires allocating more of the settlement to non-wage damages like emotional distress. You should consult a tax professional to see if this approach could benefit you.
Explore Tax-Free Settlement Structures
One way to potentially avoid taxes altogether is to structure the settlement as periodic payments via an annuity or structured settlement.
When properly set up, each payment can be partly tax-free as a return on your original investment. An attorney experienced in these settlements can advise if it’s feasible in your case.
Deduct Attorney Fees and Costs
Don’t forget that legal fees and court costs are deducted directly from your taxable settlement amount. Be sure to keep receipts and records to back up these deductions.
Contribute to Retirement Accounts
If your settlement occurs before year-end, consider maximizing contributions to tax-advantaged retirement plans like 401(k)s, IRAs, HSAs, etc. This reduces your taxable income for that year.
Donate a Portion
You can also lower your tax bill by donating a portion of the settlement to a qualified charity. Just be sure to obtain a contemporaneous written acknowledgment from the charity.
When Must Taxes Be Paid on a Settlement?
In most cases, you don’t have to worry about the tax impact until tax time the following year. Settlement taxation follows the same cash-based accounting rules as regular income.
So, if you receive the settlement in 2022, you won’t owe taxes until you file your 2022 return in April 2023.
However, it’s wise to set aside a conservative estimate of what you might owe to avoid penalties. Consulting a tax advisor early on can help you plan and even make estimated payments if desired.
The exception is structured settlements, where taxes are paid incrementally over time as the payments are received.
Report Your Settlement Accurately and Maintain Records
Once you’ve received the settlement, it’s crucial to report it properly on your tax return. Misreporting settlement income can lead to an audit, penalties, interest, and even tax evasion charges in extreme cases.
- Report your gross settlement amount on Form 1040, even if excludable
- Note any excluded amounts and basis recovery deductions
- Keep detailed records of settlement documents, attorney fees, damages analysis, etc.
An experienced tax attorney or CPA can provide guidance on correctly navigating settlement taxation. With the right moves, you can hopefully keep more of the money you worked so hard to obtain.
Mistakes to Avoid With Settlement Taxes in Georgia
It’s easy to make costly mistakes when navigating settlement taxes:
- Not planning for taxes – Failing to set aside money to pay taxes could leave you unable to afford the tax bill.
- Spending the money prematurely – Many people spend settlement funds too quickly and then don’t have the cash to pay taxes.
- Not considering state taxes – Georgia state income taxes also apply to taxable settlement funds. Factor this in.
- Thinking your attorney will handle taxes – While they may advise on tax implications, you are ultimately responsible for payment.
- Failing to report properly – Any taxable settlement income must be reported accurately on your tax return.
- Not getting professional help – Work with experienced tax and legal advisors to ensure you optimize your settlement.
Proper planning is key to retaining more of your settlement after tax. Consult professionals and use the strategies outlined above to maximize the funds you keep. With smart actions, you can avoid paying excess taxes and use your settlement money to improve your life.
Consult Tax Experts Before Finalizing Your Settlement
The best way to minimize taxes and avoid problems is to consult qualified tax professionals before you agree to a settlement.
They can help structure the settlement in a tax-efficient manner and make sure proper documentation is obtained. Trying to reduce taxes later on is much more difficult.
Receiving tax-free settlement funds may sound too good to be true. But with proper planning based on your specific situation, avoiding or lowering taxes on your settlement under Georgia and federal tax laws is possible.
The keys are understanding what portions of your settlement are taxable, taking advantage of exclusions and deductions, and working with experienced legal and tax advisors. With the right approach, you can obtain the maximum net recovery possible.
Avoiding taxes on settlement money FAQs
Are all lawsuit settlements taxable?
No, not all lawsuit settlements are taxable. Whether or not your settlement is taxable depends on the type of settlement and the nature of the damages awarded. For example, settlements for physical injuries or illness are generally tax-free, while settlements for punitive damages or emotional distress may be subject to taxes.
What happens if I don’t report my lawsuit settlement on my tax return?
If you fail to report your lawsuit settlement on your tax return, the IRS may discover it during an audit or through other means. In such cases, you may be charged penalties and interest on the unreported amount. It is always best to report your settlement and consult with a tax professional to ensure compliance with tax laws.
Can I deduct legal fees from my lawsuit settlement?
In some cases, you may be able to deduct legal fees from your lawsuit settlement. However, the tax laws regarding deductions for legal fees vary depending on the nature of the lawsuit. It is advisable to consult with a tax professional to determine whether or not you can deduct legal fees from your settlement amount.