How to avoid paying taxes on a settlement legally

Do you have to pay taxes on a settlement?

Like most things related to taxes, the answer isn’t easy. You may have to pay taxes on certain types of settlements, while others are tax-exempt.

The IRS generally considers settlements taxable. However, the type of claimAn insurance claim is a request you make to your insurance company for coverage after your car is damaged or you have an accident. You can file a claim online, by phone, or in writing. and settlement determine whether or not the compensation is taxed. 

“Whether settlements are subject to taxation depends on the cause of the settlement and to what extent the settlement covers lost wages and compensation,” says Alex Durante, senior economist at The Tax Foundation, a nonpartisan tax policy nonprofit think tank.

Settlements to pay for property replacement and medical bills are typically not taxed since the money simply replaces money you’ve already spent. However, settlements for things like lost wages and some forms of pain and suffering are taxed.

For example, lost wages are taxable since you would be paying taxes on your wages regardless of the accident. While the tax rates are usually similar, you could pay much more if you receive a large lump sum to cover lost wages for an extended period, because it puts you in a higher tax bracket.

“Damages that are paid to compensate for lost income would not be subject to any income taxation. However, punitive damages that are paid in such a settlement would be subject to tax,” Durante says. 

Settlements for pain and suffering are a little trickier. You don’t have to pay taxes if your settlement is based on physical pain and suffering. However, you may have to pay taxes if your settlement is based on emotional distress that isn’t a result of a bodily injury, such as anxiety after an accident.

How to avoid paying taxes on settlement money

After an accident, the last thing you want is to have to share your settlement with the IRS. Fortunately, there are ways to lower your tax liability, such as allocating the settlement, taking a structured settlement, and working with a tax professional.

What types of settlements are tax-free?

It’s important to understand what types of settlements are taxed so that you can save as much of your settlement as possible. 

“In general, punitive damages are subject to income taxation, except in wrongful death settlements,” Durante says.

However, these two main types of settlements aren’t taxed:

• Settlements to repair or replace vehicles or property aren’t taxed. The purpose of insurance is to return your property to its pre-accident condition. You aren’t gaining financially, so there is no income to tax.
• Settlements for medical bills are also not taxed. The insurer usually pays the hospital directly or reimburses you for bills you’ve already paid. Again, there is no income, only paying for medical bills due to the accident.

Avoid taxes by structuring the settlement

You can receive your settlement in one lump sum or a structured settlement. How you choose to accept it can affect your tax liability. 

Unless you need the money immediately, receiving a lump sum probably isn’t your best bet. Your settlement can be counted as income, moving you to a higher tax bracket. In turn, you’ll have to pay much higher taxes.

If you don’t need all of your settlement upfront, you can choose a structured settlement. A structured settlement spreads out the money you receive. The settlement goes to a reputable life insurance company, which will pay you monthly. Depending on your settlement and needs, you can receive payments for years or possibly the rest of your life. By spreading out the payments, your tax bracket stays the same, resulting in lower taxes.

Properly allocate the settlement

The way you allocate your settlement makes a significant difference in the amount of taxes you have to pay. You can reduce your tax liability by itemizing the settlement since some claims are tax-exempt.

For example, if you receive a $100,000 settlement without itemizing what the money is for, you may have to pay taxes on the entire amount. However, if $20,000 is for medical bills and $40,000 is to replace your vehicle, you only have to pay taxes on the remaining $40,000 for lost wages.

Additionally, allocating your attorney fees correctly can save you significantly in taxes. If allocated properly, attorney fees can be tax-deductibleThe deductible is the amount you pay out of pocket for a covered loss when you file a claim., lowering your liability.

Use tax-deferred or protected accounts

Another way to limit tax liability is to put your settlement into tax-deferred or protected accounts. Take advantage of a 401(k) or IRA to avoid paying taxes when you get your settlement. Although you’ll have to pay taxes when you withdraw the money later, you can earn interest on the entire amount until then.

You can also use protected accounts, such as an offshore trust, to reduce your initial tax liability. By placing the money in such an account, you can earn interest and diversify the account, such as with real estate or cryptocurrency. While you will still have to pay taxes on the money, it can delay the payments until the money is used.

Get professional advice

Seeking advice from a tax professional before receiving a settlement can provide peace of mind, ensuring you have the smallest tax liability possible. The tax code can be complex, especially when dealing with a large insurance settlement, so working with a professional can help you avoid paying unnecessary taxes. 

How to minimize taxes on a lump sum payment

The best way to lower your tax liability on a lump-sum settlement is to allocate the settlement. Since some claims are untaxed, like medical bills, allocating more of your settlement to those claims keeps your taxes lower.

Working with a tax professional will lower your tax liability significantly. They can advise you on how to avoid taxes and keep more of your settlement.