Cash settlement payments come in a variety of forms. Court verdicts and out-of-court settlements account for the majority of cash settlements, but other types exist. Lotteries, insurance settlements and structured settlement sales are just a few other kinds of cash settlements. No matter the type, most settlements have tax implications. A decision as seemingly simple as whether to take a lump-sum payment or a structured settlement has far-reaching tax liability ramifications, and you should be aware of when and how to report such income on your tax returns.
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Recognise the type of cash settlement you have received. If it was a lump-sum award, for example, your tax liability will be much more than if you received a structured settlement or annuity.
Research the different tax reporting requirements for the type of settlement you have received. For instance, a lump-sum settlement will have to be reported on your tax returns in its totality for the year it was received. A structured settlement, however, is tax free for the life of the annuity, including interest proceeds, and there are no money management concerns. The payments are guaranteed, usually through an insurance company overseeing the annuity.
Determine the nature of the settlement and the tax implications. A personal injury settlement, for example, is divided into different parts, each with its own tax issues. Compensatory damages (those monies awarded for lost income due to injury and resulting emotional distress) are not taxable. Punitive damages, most forms of emotional distress awards and interest accrued from lump-sum payments are taxable.
Find out whether or not you have a choice between a lump-sum payment and a structured settlement. If you do, the annuity offers obvious tax benefits. Even lottery winnings taken as an annuity, while not tax free, will result in a significant increase in actual take-home pay.
Enter your taxable cash settlement earnings on line 21 of Form 1040 ("Other Income"). This will increase your total taxable income for the year by the amount of the settlement payment. For example, if your gross income for the year---your W-2 wages and earnings---was £26,000 and you received a cash settlement of £32,500, your taxable income will be £58,500, significantly increasing your tax burden and taking a much larger bite out of both your earnings and the settlement money.
Tips and warnings
- While rules vary from state to state, a person who wins £0.6 million in a state lottery and takes payment in a lump sum can expect to receive less than half---even as low as a third---after taxes. Consider an annuity payment instead.
- Although most cash settlements will be included on Form 1040, line 21 ("Other Income"), you may receive a Form 1099 in the mail. Consult a tax adviser for any cash settlement tax concerns.
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