When individuals or businesses are involved in legal disputes that result in settlements or judgments in their favor, one common question arises. Do you pay taxes on lawsuit settlements? The answer to this question can vary depending on the nature of the lawsuit, the type of damages awarded, and specific circumstances surrounding the case. Let’s look into the tax implications associated with lawsuit settlements.
Taxability of Lawsuit Settlements
Internal Revenue Code (IRC) Section 61 broadly defines gross income as all income from whatever source, unless specifically excluded by another provision of the tax code. In addition, IRC Section 104 provides an exclusion from gross income for certain types of compensation received in legal settlements or judgments. In other words, you don’t have to count certain types of money you receive from legal settlements or insurance if they’re related to personal physical injuries or sickness. However, the exact circumstances surrounding the case will help determine the taxability of settlements and judgements. Let’s look at different types of lawsuit settlements.
Compensatory Damages vs. Punitive Damages
Compensatory damages are intended to compensate the plaintiff for losses suffered. This typically includes damages for physical injuries, emotional distress, lost wages, medical expenses, and property damage. Compensatory damages are usually not taxable. They are meant to restore the individual to the position they were in before the injury or loss occurred. Punitive damages, on the other hand, are awarded to punish the defendant for particularly egregious behavior and to deter others from engaging in similar conduct. In many cases, punitive damages are taxable as ordinary income.
Physical Injury or Sickness
If a lawsuit settlement is related to physical injury or sickness, the compensatory damages received are generally not taxable. This includes damages for medical expenses, pain and suffering, and loss of consortium. Again, if a portion of the settlement is allocated to punitive damages or other non-compensatory damages, that portion may be taxable.
Emotional Distress
Emotional distress damages are a bit trickier when it comes to taxation. Typically, damages awarded for emotional distress are taxable, even if there were physical symptoms as well. Section 104 does not consider headaches, insomnia, or stomach conditions as qualified physical symptoms. However, if you experienced a physical injury or sickness, damages might be tax-free.
Lost Wages and Lost Profits
Compensation for lost wages and lost profits is typically taxable as ordinary income. This includes settlements related to employment discrimination, wrongful termination, retaliation, or lost business income. This is because you are typically not suing because of physical injury. Keep in mind that not only will income taxes be due in this type of settlement, but also other wage-related taxes as well, including FICA taxes.
Attorney’s Fees
Attorney’s fees paid from a settlement may or may not be deductible, depending on the specifics of the case and applicable tax laws. In general, cases dealing with employment discrimination, retaliation, or whistleblower claims can deduct legal fees “above the line.” An “above-the-line” deduction is one you can claim on your tax return before calculating your adjusted gross income (AGI). As of the passing of the 2017 Tax Cuts and Jobs Act, you cannot deduct legal fees for most other cases. In addition, the Act also requires individuals to pay tax on the total gross settlement. This includes money paid to your attorney. For example, if your settlement was $20,000 and the attorney’s received $5,000, you’d pay tax on the entire $20,000 settlement and not just on your $15,000 cut. The attorney also pays their own share of tax on their cut.
Reporting Lawsuit Settlements on Tax Returns
When it comes to reporting lawsuit settlements on tax returns, it’s essential to accurately categorize the income and follow the IRS guidelines. If you receive settlement income, you’ll typically receive IRS Form 1099-MISC. This form is used to report miscellaneous income, including settlements. Keep in mind, however, that you won’t receive this form if your settlement income is not taxable. There may be a few exceptions to which form you’ll receive. For example, if you receive back pay from your employer, these proceeds would be reported on your W-2 Form. In addition, if you received settlement interest, you should receive IRS Form 1099-INT.
Remember, even if you don’t receive a Form 1099, you are still responsible for reporting taxable income from lawsuit settlements on your tax return. Keep detailed records of the settlement, including any documentation related to the lawsuit, legal fees, and the allocation of damages.
Tax Help for Those Who Won a Lawsuit Settlement
Navigating the tax implications of lawsuit settlements can be complex. You should consult with a tax professional or attorney for guidance tailored to your specific situation. Understanding the distinction between compensatory and punitive damages, and the tax treatment of different types of settlements, is crucial for accurately reporting income and avoiding potential tax issues in the future. By staying informed and seeking expert advice when needed, individuals and businesses can effectively manage the tax consequences of legal settlements. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.
Today, Optima Tax Relief Lead Tax Attorney, Phil, talks about his three takeaways from the current tax landscape.
IRS Interest Rates Could Increase
For much of the pandemic, we saw IRS interest rates hold steady. For example, the interest rate accumulating on unpaid taxes was 3% for half of 2020 and all of 2021. In April 2022, we saw it increase by 1% each quarter until it hit 6%. Now, the second quarter of 2024 will mark the third consecutive quarter with a rate of 8% for interest. The question remains: Will the rate continue to increase? Phil thinks so. It’s been said numerous times that now is a terrible time to owe the IRS. Spiking interest rates mean more expensive penalties and interest. Taxpayers should act immediately to get their tax issues resolved.
Back Taxes Affect Your Passports
If you owe a significant amount of back taxes and the IRS has issued a certification to the U.S. State Department, they can deny your passport application or revoke your current passport. But don’t worry. Before the IRS certifies your tax debt to the State Department, they will notify you in writing about the impending certification. You have the opportunity to resolve your tax debt, enter into a payment plan, or request other relief options before the certification occurs.
The 1099-K is a Wild Card
The reporting thresholds for Form 1099-K have changed quite a bit in the past few years. Remember, Form 1099-K is an informational tax form used to report certain types of payment card and third-party network transactions to the IRS. If you collect payments for your business through PayPal, Venmo, or others, you probably know about Form 1099-K. As of now, you would receive a 1099-K in 2025 if you had transactions of $5,000 or more in 2024. However, a much smaller $600 threshold will go into effect for tax year 2025. Remember, you should report this taxable income even if you do not receive IRS Form 1099-K.
Disposable income serves as a key economic indicator. It reflects the financial health and spending power of individuals and households. It represents the money available after taxes, providing a glimpse into how much individuals can spend, save, or invest. However, taxes play a significant role in shaping disposable income, influencing spending patterns and economic behaviors. In this article, we break down the concept of disposable income, explore its significance, and examine how taxes impact its utilization.
What is Disposable Income?
Disposable income (DI) refers to the amount of money individuals or households have available for spending and saving after paying taxes to the government. It is the income remaining once taxes, including income tax, payroll tax, and any other deductions, have been subtracted from gross income. Essentially, it is the money that individuals can freely allocate to consumption, savings, investments, or debt repayment.
Significance
Understanding disposable income is crucial for assessing an individual’s or household’s financial well-being. It serves as a barometer for consumer spending, which is a significant driver of economic growth. Higher DI generally correlates with increased consumer spending. This in turn stimulates demand for goods and services, leading to economic expansion.
Moreover, it influences saving and investment behaviors. Individuals with higher disposable income can save more for emergencies, retirement, or large purchases. Additionally, it enables individuals to invest in assets such as stocks, bonds, real estate, or retirement accounts, fostering wealth accumulation and financial security over the long term.
Impact of Taxes on Disposable Income
Taxes have a direct impact on disposable income, as they reduce the amount of money available for consumption and saving. In addition to federal income taxes, there is also state income tax, which varies across the country with different rates, deductions, and exemptions affecting DI differently.
Income Tax
Income tax is a significant contributor to reducing DI. It is imposed on earned income, including wages, salaries, bonuses, and investment income such as interest and dividends. Progressive income tax systems levy higher tax rates on higher income levels, leading to a greater reduction in disposable income for high earners.
Payroll Taxes
Payroll taxes, which fund social insurance programs such as Social Security and Medicare, also diminish disposable income. These taxes are typically withheld from employees’ paychecks by employers. Payroll taxes are comprised of a fixed percentage of wages up to a certain limit. While payroll taxes are regressive, meaning they impose a higher burden on low-income earners, they still impact DI for all workers.
Consumption Taxes
Consumption taxes, such as sales tax or value-added tax (VAT), are levied on goods and services at the point of purchase. Unlike income taxes, which are based on earnings, consumption taxes affect spending directly, reducing disposable income with each transaction. The regressive nature of consumption taxes means that they can disproportionately impact low-income individuals, who may spend a higher proportion of their income on taxable goods and services.
Use in Taxes in Disposable Income
While taxes reduce DI, how individuals allocate their remaining funds can have tax implications as well. Several strategies can help minimize tax liabilities.
Retirement Contributions
Contributing to retirement accounts such as 401(k) plans or individual retirement accounts (IRAs) can reduce taxable income while simultaneously saving for the future. Contributions to these accounts are often tax-deductible, lowering current tax obligations and potentially increasing disposable income.
Tax-Advantaged Investments
Investing in assets with favorable tax treatment, such as municipal bonds or certain retirement accounts, can shield investment income from taxes or defer tax liabilities. This helps preserve more DI for the present.
Tax Credits and Deductions
Taking advantage of available tax credits and deductions can reduce overall tax liabilities, effectively increasing disposable income. Common tax credits include the Earned Income Tax Credit (EITC) and the Child Tax Credit, while deductions such as mortgage interest or charitable contributions can lower taxable income.
Tax Help in 2024
DI serves as a vital metric for assessing financial well-being and economic vitality. Taxes play a crucial role in shaping DI, influencing spending, saving, and investment decisions. Understanding the impact of taxes can empower individuals to make informed financial choices, optimizing their resources and maximizing their financial freedom. By employing tax-efficient strategies and leveraging available resources, individuals can effectively manage their disposable income, enhancing their economic security and prosperity. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.
Filing taxes can be a stressful ordeal for many individuals, but for some, the April deadline comes too soon. If you’re one of the many Americans who filed for a tax extension, you’ve gained a little breathing room. However, it’s essential not to let that extra time slip away without acting. Here’s a guide on what to do after filing a tax extension to ensure a smooth process and avoid any potential pitfalls.
Review Your Situation
First and foremost, take a moment to reassess your financial situation. The extension deadline has given you time to gather necessary documents and reconsider certain deductions and credits. Review your financial records, receipts, and any changes in your circumstances that may impact your taxes. This step is crucial for accurate and thorough tax filing.
Understand the New Deadline
While filing for an extension grants you additional time to submit your tax return, it’s vital to understand the new deadline. Typically, the extended deadline falls six months after the original due date. The tax extension deadline in 2024 is October 15. Mark this date on your calendar and set reminders to avoid any last-minute rush.
Complete Your Tax Return Promptly
Don’t fall into the trap of procrastination. Even though you’ve been granted an extension, it’s best to complete your tax return as soon as possible. The longer you wait, the more likely you are to encounter unexpected issues or delays. Aim to finalize your taxes well before the extended deadline to avoid any last-minute stress.
Pay Any Owed Taxes
It’s crucial to remember that a tax extension does not grant an extension for paying any taxes owed. If you anticipate owing taxes, it’s best to estimate the amount and pay as much as possible before the original deadline to minimize penalties and interest. Failure to pay on time can result in additional fees, so make paying any owed taxes a priority.
Consider Electronic Filing
Electronic filing is a convenient and efficient way to submit your tax return, especially if you’re working with a tight deadline. Many tax preparation software programs offer e-filing options that can streamline the process and help ensure accuracy. Additionally, electronic filing typically results in faster processing and quicker refunds, if applicable.
Seek Professional Assistance if Needed
If your tax situation is complex or you’re unsure about certain aspects of your return, don’t hesitate to seek professional assistance. A qualified tax professional can provide guidance, ensure compliance with tax laws, and help maximize deductions and credits. While there may be a cost associated with hiring a tax preparer, the peace of mind and potential savings can outweigh the expense.
Plan for the Future
Once you’ve completed your tax return and filed any necessary paperwork, take the opportunity to plan for the future. Consider implementing strategies to better prepare for next year’s taxes, such as keeping detailed records throughout the year, exploring tax-saving opportunities, and adjusting your withholding if necessary. Planning ahead can help alleviate stress and ensure a smoother tax filing process in the future.
Tax Help for Those Who Filed a Tax Extension
Filing a tax extension can provide much-needed relief for those facing a time crunch or dealing with complex tax situations. However, it’s essential to use this extra time wisely and take proactive steps to complete your tax return accurately and on time. By reviewing your situation, understanding the new deadline, promptly completing your tax return, paying any owed taxes, considering electronic filing, seeking professional assistance if needed, and planning for the future, you can navigate the post-extension period with confidence and ease. Optima Tax Relief is the nation’s leading tax resolution firm with over a decade of experience helping taxpayers with tough tax situations.
Inheriting assets can be a bittersweet experience. While it often signifies the passing of a loved one, it can also provide financial stability and opportunities for the future. However, along with the emotional and financial aspects of inheritance come tax implications, especially regarding inherited accounts. Understanding how taxes apply to inherited accounts is crucial for effective estate planning and financial management. In this article, we’ll explore the complexities of taxes on inherited accounts and explore strategies to navigate them.
SECURE Act
It’s important to know that taxes on inherited accounts is an extremely complex topic. This topic was made even more confusing by the 2019 SECURE Act and 2022’s SECURE Act 2.0. To put it simply, the SECURE Act focuses on a few key areas to improve retirement plans.
Expanded Access: Requires employers to allow long-term part-time employees who work at least 500 hours per year for three consecutive years to participate in their employer’s 401(k) plan.
Increased RMD Age: The age at which individuals must start taking required minimum distributions (RMDs) from their retirement accounts was raised from 70½ to 72. It was raised to 73 in 2023. This change allows individuals to keep their retirement funds invested for a longer period, potentially increasing their savings.
Birth or Adoption Expenses: Allows penalty-free withdrawals of up to $5,000 from retirement accounts for expenses related to the birth or adoption of a child. While the withdrawal is penalty-free, income tax still applies to the distribution.
Elimination of “Stretch” IRAs: Eliminates the “stretch” IRA provision for most non-spouse beneficiaries. Previously, non-spouse beneficiaries could stretch distributions from inherited IRAs over their lifetimes, allowing for potentially significant tax-deferred growth. Now, most non-spouse beneficiaries are required to withdraw the entire inherited IRA balance within 10 years of the original account holder’s death, potentially accelerating tax liabilities.
Knowing these provisions is key to understanding taxes on inherited accounts. The way a surviving spouse is taxed is different from the way a child or relative is taxed. Similarly, non-relatives are taxed differently. Knowing what your options are if you inherit an account can save you time, money, and a headache.
Types of Inherited Accounts
Keeping the SECURE Act in mind, we can now look at the different types of inherited accounts. Inherited accounts come in various forms, including retirement accounts like Individual Retirement Accounts (IRAs), employer-sponsored retirement plans such as 401(k)s, taxable investment accounts, and other financial assets. Each type of account may have different tax implications for beneficiaries. In most scenarios, you may inherit IRAs, employee-sponsored retirement plans, and investment accounts.
Traditional and Roth IRAs
Perhaps the most important factor that determines options when inheriting accounts is your relationship to the deceased. When inheriting a traditional IRA, beneficiaries typically must pay income tax on distributions they receive. The tax is based on the beneficiary’s individual tax rate. However, if the deceased had already begun taking required minimum distributions (RMDs), the beneficiary may need to continue taking them based on their life expectancy.
In contrast, inheriting a Roth IRA usually offers tax advantages. Qualified distributions from a Roth IRA are tax-free, so beneficiaries can potentially enjoy tax-free growth on inherited assets. However, non-qualified distributions may be subject to taxes and penalties. For example, if the Roth account is less than 5 years old at the time of withdrawal, the withdrawal may be subject to income tax.
Non-Spouse Beneficiaries
If you inherited an account from a parent, relative, or anything other than a spouse, your options are more limited. For example, you cannot roll inherited IRA funds into an IRA in your name. Also, if you plan to take RMDs using the life expectancy method, you must meet one of the following requirements:
You inherited the funds from someone who died in 2019 or earlier
You are chronically ill or disabled
You are more than 10 years younger than the deceased account owner
You are a minor child of the deceased account owner. If this is the case, you must use the life expectancy method until you reach age 18.
If you don’t meet any of these criteria, you can spread the withdrawals over a 10-year period. Alternatively, you can withdraw over 5 years or take a lump sum withdrawal.
Employer-Sponsored Retirement Plans
Similar to traditional IRAs, beneficiaries of employer-sponsored retirement plans like 401(k)s may need to pay income tax on distributions they receive. You could take a lump sum distribution, but it will be taxed as ordinary income. You could also roll the funds into your own 401(k) or IRA. If you do this, you’ll follow the same withdrawal rules. For instance, you be penalized for early withdrawals, and you must start taking RMDs by age 73. If you choose to transfer the funds into an inherited IRA account, you can make early withdrawals. On the other hand, you don’t need to move the funds at all. You can leave it in the account and take RMDs when required. However, if you are over 59½ and your spouse began taking RMDs before they passed, you can continue those withdrawals or delay it until you reach age 73 without any penalty.
Non-Spouse Beneficiaries
Once again, non-spouse beneficiaries have less options than spouses. You have three options for this type of account.
Transfer funds into an inherited IRA: This option requires the funds to be completely withdrawn within 10 years. If the money was pre-tax, you’ll pay tax on the withdrawals. If you convert a pre-tax 401(k) into a Roth IRA, you’ll likely owe taxes at the time of conversion. Withdrawing from a Roth 401(k) or converting the account to a Roth IRA has no tax implications.
Take a lump sum payment: This option generally results in a large tax bill. If you inherit a pre-tax 401(k), you’ll pay at your ordinary tax rate. If it’s a Roth 401(k), there are no tax implications.
Leave the funds and withdraw over 10 years: You can leave the funds in the original account, but you still need to meet the 401(k) 10-year rule.
Inherited Stock
Inheriting taxable investment accounts generally involves capital gains taxes. When beneficiaries sell inherited assets, they may incur capital gains tax based on the difference between the asset’s value at the time of inheritance and its value at the time of sale. However, inheriting assets also offers a “step-up” in basis, which can reduce capital gains taxes by resetting the cost basis to the asset’s value at the time of the original owner’s death.
Here’s an example. Let’s assume you sell inherited stocks one year after inheriting them. The stocks were worth $100,000 when you inherited them, and you sold them for $120,000.
Capital Gain = Sale Price – Fair Market Value at Inheritance
Capital Gain = $120,000 – $100,000 = $20,000
If your capital gains rate is 15%, you’d owe $3,000 in capital gains tax.
Capital Gains Tax = Capital Gain × Capital Gains Tax Rate
Capital Gains Tax = $20,000 × 0.15 = $3,000
Tax Help for Those Who Inherited Accounts
Inheriting accounts comes with both financial opportunities and tax obligations. Understanding the tax implications of inherited assets is crucial for maximizing their value and minimizing tax liabilities. By implementing strategic tax planning strategies and seeking professional guidance, beneficiaries can navigate the complexities of taxes on inherited accounts effectively. Optima Tax Relief has a team of dedicated and experienced tax professionals with proven track records of success.
