How are structured settlements taxed? Learn the tax rules, tips, and what to avoid to make smart financial decisions.
How Are Structured Settlements Taxed? Learn What You Must Know
Ever wondered if you’ll owe taxes on a structured settlement? Or if taking a lump sum instead will land you a bigger tax bill? You’re not alone. Many people get confused when it comes to the tax rules on settlement money. Let’s break it all down in simple terms.
Here’s the short answer: Structured settlements from personal injury or wrongful death cases are usually tax-free. But it’s not always black and white. It depends on the type of case, how the money is paid, and what it covers.
Let’s dive deeper and make sure you’re not missing anything that could cost you later.
What Is a Structured Settlement?
A structured settlement is a financial agreement that pays you in regular installments over time instead of giving you a lump sum. It usually happens after a lawsuit, like a personal injury case.
Why people choose structured settlements:
- Steady income over time
- Avoids blowing through a large lump sum
- Often comes with tax advantages
These payments are often funded through annuities bought by the defendant or their insurer.
Are Personal Injury Settlements Taxable?
Nope — not usually. If you receive a settlement for physical injuries or physical sickness, the IRS doesn’t tax it.
Here’s what’s typically tax-free:
- Medical costs
- Pain and suffering due to physical injuries
- Lost wages (if directly from the injury)
- Wrongful death compensation
⚠️ But there are exceptions. So keep reading!
When Can a Structured Settlement Be Taxed?
Not all settlement money gets the tax-free pass. Some parts of a settlement can be taxed under certain conditions.
You may owe taxes if:
- You’re receiving punitive damages
- The payment is for emotional distress without physical harm
- You got interest on the settlement money
- You’re getting compensation for breach of contract
Here’s a quick look:
| Type of Settlement Income | Taxable? |
|---|---|
| Physical injury compensation | ❌ No |
| Punitive damages | ✅ Yes |
| Emotional distress (no injury) | ✅ Yes |
| Interest on payments | ✅ Yes |
| Lost wages (from injury) | ❌ No |
What About Emotional Distress Settlements?
This one’s tricky.
- If your emotional distress came from a physical injury, it’s not taxable.
- If you only suffered emotional harm — like from workplace harassment — the IRS says that is taxable.
You must also pay tax on any portion of your payout used for previously deducted medical expenses.
Is Lost Income Taxed Differently in Settlements?
Not always.
If the lost wages are part of a personal injury settlement, they’re tax-free. But if you’re getting back pay for, say, a wrongful termination case, the IRS will tax that as regular income.
Key Rule: Was the income lost due to injury? If yes → tax-free. If no → taxable.
What If You Sell Your Structured Settlement?
Selling your structured settlement to a third party can trigger tax consequences.
Here’s why:
- The lump sum you get may be taxed
- You might lose some long-term tax-free benefits
Always talk to a tax advisor before selling any settlement rights.
Tax Impact of Interest and Investment Income
Any interest or investment income earned from your settlement is taxable. That includes:
- Interest from a lump sum put into a savings account
- Dividends from investing your settlement money
| Source of Income | Tax Treatment |
| Interest from annuity | ✅ Taxable |
| Stock dividends from proceeds | ✅ Taxable |
| Original settlement amount | ❌ Not Taxable |
Be smart about where you park your money after receiving it.
Can You Deduct Legal Fees? ⚖️
Only in limited cases.
If your settlement is taxable (like in an employment lawsuit), you might be able to deduct attorney fees. But thanks to the 2017 tax reform, miscellaneous deductions are mostly gone.
Better approach? Ask your attorney to structure the legal fees in the settlement terms.
How Taxes Differ Between Lump Sums and Structured Settlements
Here’s the main difference:
- Structured settlements often protect you from big tax hits.
- Lump sums may create interest or investment income that is taxable.
| Payment Type | Tax Risk |
| Structured Settlement | Low |
| Lump Sum | Moderate to High |
State vs. Federal Taxes
Federal tax rules apply to most settlements, but state taxes may also kick in. Each state has different tax laws. Some may tax certain types of income even if the IRS doesn’t.
Check your state’s tax authority website or consult a local CPA.
IRS Rules You Should Know
The IRS guidelines are found in:
- IRC Section 104(a) – outlines exclusions for personal injuries
- Publication 4345 – covers how settlements are taxed
Stay updated. IRS interpretations can change over time.
What If You’re Receiving Payments Over Time? ️
Structured settlements are great because:
- They break down income into manageable pieces
- They maintain tax-exempt status (if injury-related)
But once you start earning interest or reinvesting funds, you may owe taxes.
Track your payments. Keep good records.
Smart Tips to Minimize Tax Burden
Want to stay on the IRS’s good side? Follow these tax-savvy moves:
- Get tax advice before accepting or altering any settlement.
- Keep documentation on what part of your payout is tax-free.
- Avoid selling your structured settlement unless absolutely needed.
- Don’t commingle tax-free funds with taxable investment income.
- Ask your lawyer to clearly separate taxable and non-taxable parts.
What Happens If You Don’t Report It Right? ⚠️
You could face:
- IRS penalties and interest
- Back taxes
- Delayed refunds
Always double-check your 1099 forms, specially if you’ve sold or transferred payments.
When to Call a Pro
Call a tax pro if:
- Your settlement isn’t for physical injury
- You’re unsure how to report it
- You’re selling or modifying your structured settlement
A CPA or tax attorney can help you save thousands and stay compliant.
Final Thoughts: Tax Peace of Mind
Understanding how structured settlements are taxed isn’t just about avoiding trouble — it’s about making the most of your money. With the right info and planning, you can protect your income and breathe easier come tax time.
Remember:
- Most personal injury structured settlements are tax-free ✅
- Other types (emotional distress, punitive damages) may be taxable ⚠️
- Selling your settlement can change your tax picture
Plan smart. Sleep well.
FAQs
Are structured settlements from injury cases taxable?
No, most structured settlements for personal injuries are tax-free.
Do I pay tax if I sell my structured settlement?
Yes, lump sum proceeds from a sale may be taxed.
Is emotional distress settlement money taxable?
Yes, if not linked to physical injury, it’s usually taxable.
Are interest payments from a structured settlement taxed?
Yes, interest or investment gains are taxable.
Can I deduct legal fees from my taxable settlement?
Sometimes. Depends on the type of case and how fees were structured.
References
https://www.irs.gov/faqs/interest-dividends-other-types-of-income/structured-settlements
https://www.nolo.com/legal-encyclopedia/structured-settlement-taxation.html
https://turbotax.intuit.com/tax-tips/income/are-lawsuit-settlements-taxable/L2fyzblJ8
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