I Received a $100K Car Accident Settlement! Isn’t It Tax-Free?
Not So Fast—Uncle Sam Wants His Cut!
Thankfully, I don’t get asked about the tax implications of lawsuit settlements often, but I hear about it enough that I’ll cover the topic briefly.
A few months ago, an ER colleague of mine was in a car accident and received a $100,000 settlement from the lawsuit. Fortunately, she sustained only minor cuts and bruises, and the $100,000 was primarily for punitive damages—monetary compensation for the reckless behavior of the person who caused the accident.
But, she had to spend $40,000 on attorney fees.
She asked me, “how much of the $100k settlement is taxable?”
Is it the full $100,000?
just $60,000 after deducting legal fees
Or could it be tax-free?
The Unfortunate Answer: The Entire $100,000 Is Taxable
Here’s a key summary of how lawsuit settlements are taxed under Internal Revenue Code §104:
Physical Injury: If a settlement is for physical injuries, it is tax-free.
Punitive Damages: Even in cases involving physical injury, punitive damages are always taxable. Bummer!
Emotional Distress: If a settlement is for emotional distress alone (without physical injury), it is taxable. :(
Medical Expenses: If a settlement is for medical expenses to treat physical injuries or emotional distress (e.g., PTSD) resulting from a physical injury, it is tax-free.
Since her $100,000 settlement was classified as punitive damages, the entire amount is fully taxable. :(
What About Legal Fees?
She asked whether she could deduct the $40,000 in attorney’s fees to offset her $100k of taxable income.
Before 2018, legal fees were deductible as a miscellaneous itemized deduction, subject to the 2% of AGI threshold.
For example, if her AGI was $300,000, the portion of legal fees exceeding 2% of AGI ($300,000 x 2% = $6,000) would be deductible. Since her legal fees were $40,000, only the amount exceeding $6,000, meaning $34,000 ($40,000 - $6,000) would be deductible as an itemized deduction.
From 2018 to 2025, under the Tax Cuts and Jobs Act (TCJA), miscellaneous itemized deductions, including legal fees, are not deductible, unless the lawsuit involves employment discrimination or whistleblower claims, which does not apply in this case. Therefore, her $40,000 in legal fees would, unfortunately, not be tax deductible.
What Does This All Mean?
Even though she only receives $60,000 after legal fees, she must pay tax on the full $100,000.
Assuming a 40% combined federal, state income tax, and net investment income tax, she owes $40,000 in taxes.
Here’s how the money breaks down:
Pays $40,000 to her attorney
Pays $40,000 to Uncle Sam!
Keeps only $20,000.
That’s a huge tax hit!
What Could Have Been Done Differently (solely related to tax matters)?
Negotiate Settlement Terms – ask your attorney whether it is possible to allocate more of the settlement toward physical injuries or medical expenses, as these amounts are not taxable under IRS §104(a)(2)
Understand the Tax Consequences Before Signing – carefully review the settlement agreement with both an attorney and a tax professional to ensure that it is structured in the most tax-efficient way, minimizing taxable portions of the settlement.
Final Thoughts
Don’t spend your settlement money until you fully understand your tax liability—the last thing you want is to turn an already stressful event into an even bigger financial burden.
Work with both a tax professional and an attorney before finalizing the agreement to maximize what you keep - rather than making Uncle Sam richer!