Receiving a personal injury settlement can provide much-needed financial relief after an accident. However, it’s crucial to be aware of potential tax implications. Many people are unaware that specific settlement components may be subject to taxation.

It’s also important to recognize the right to negotiate for a higher settlement amount that accounts for these potential tax liabilities. According to the IRS, portions of personal injury settlements, such as compensation for lost wages and punitive damages, can be taxable.

With personal injury cases resulting in millions of settlements annually in the United States, understanding the tax obligations associated with these funds is essential to ensuring you retain as much of your compensation as possible.

Tax Implications of Personal Injury Settlements

When you receive a personal injury settlement, it’s important to know which portions may be subject to taxes and which are exempt. Here’s a detailed look at the tax implications of different components of personal injury settlements.

Physical Injury or Sickness

Settlements for physical injuries or sickness are exempt from taxation. According to a verifiable report from the Internal Revenue Service, if you get a settlement for bodily injuries or illness and did not take a detailed deduction for medical expenses related to the injury in previous years, this part of the settlement is not subject to taxes. This includes payments for medical bills, pain and suffering directly resulting from a physical injury, and emotional distress if it stems from a physical injury.

Lost Wages

Compensation for lost wages, however, is taxable. This portion of the settlement is treated as if you earned it through your regular employment, subject to federal and state income taxes. The IRS treats this income similarly to regular wages, so you must report it on your tax return.

Punitive Damages

Punitive damages, which are given to punish the defendant rather than compensate the plaintiff, are taxable. The IRS requires you to include punitive damages in your gross income, subjecting them to federal tax. In 2020, it was reported that over 90% of punitive damage awards in civil cases were subject to taxation, highlighting the importance of accounting for these taxes.

Emotional Distress and Mental Anguish

Payments for emotional distress and mental anguish are taxable unless they are directly related to a physical injury. If you receive a settlement solely for emotional distress and mental anguish not resulting from a bodily injury, it is considered taxable income. The IRS requires these amounts to be reported as part of your gross income.

Interest Earned

If your settlement includes interest, this interest is also taxable. Interest that accrues on the settlement amount from judgment until payment is considered taxable income and must be reported on your tax return.

Medical Expense Deductions

If you previously deducted medical expenses related to your injury and received a settlement for those same expenses, you must include the settlement amount for those deductions as income. This rule prevents taxpayers from receiving a double tax benefit for the same medical expenses.

Structured Settlements

Structured settlements, where payments are received over time instead of a lump sum, have specific tax implications. Payments received for physical injury or sickness in structured settlements are generally tax-free. However, if the structured settlement includes taxable components like lost wages or punitive damages, those portions will be taxed as received.

Reporting and Documentation

Correctly reporting your settlement on your tax return is not just crucial, it’s a responsibility. Keeping detailed records of your settlement agreement, the allocation of settlement amounts, and related documentation will help ensure accurate tax reporting and avoid potential issues with the IRS. A significant number of tax disputes arise from incorrect or incomplete reporting of settlement income.

Comprehending the tax implications of your personal injury settlement can help you better manage your finances and avoid unexpected tax liabilities. While compensation for physical injuries and sickness is typically tax-exempt, other components, such as lost wages, punitive damages, and interest, may be taxable. Since millions of personal injury settlements are awarded annually, awareness of these tax obligations is essential for financial planning.