A Guide to the Tax Implications of a Legal Settlement

A Guide to the Tax Implications of a Legal Settlement

By Douglas Goldstein, CFP® - helping olim handle U.S., IRA, investment, and brokerage accounts from Israel

This is a two-part article addressing questions that arise when people receive lump sums. For the entire article, go to: www.profile-financial.com/settlement.

I recently helped a number of people who are in the midst of receiving a cash settlement from a lawsuit, and had to point out that winning a lawsuit is not “free money.” In addition to having survived personal injury and a long-drawn out legal case, there may be tax implications to a legal settlement.

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 payments

Interest on any settlement, as with any income, is taxable and should be reported as “interest income.”

Punitive damages

Punitive damages are taxable and therefore must be reported, even if received in a settlement for personal or physical illness or injuries.

Estimate tax

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.

Free information

To get this complete article along with the IRS’s information about what you need to report to the IRS regarding a legal settlement, go to: www.profile-financial.com/settlement

Douglas Goldstein, CFP®, is the director of Profile Investment Services, Ltd. www.profile-financial.com. He is a licensed financial professional both in the U.S. and Israel. Call (02) 624-2788 for a consultation about handling your U.S. investments from Israel. Securities offered through Portfolio Resources Group, Inc. Member FINRA, SIPC, MSRB, FSI. The opinions expressed are those of the author and not those of Portfolio Resources Group, Inc. or its affiliates. Neither PRG nor its affiliates give tax or legal advice.