Does a Personal Injury Settlement Count as Income?
It doesn’t matter if the monetary award from your personal injury case comes from a settlement outside of court or results from a trial verdict. You should still be asking yourself, “does a personal injury settlement count as income on your tax return?”
The answer to that question is not a straightforward ‘yes’ or ‘no.’
The Internal Revenue Service (IRS) has set rules governing settlements and taxes, making this a complex question. The IRS often treats a settlement as separate payments instead of one large sum. Whether or not your settlement is taxable will depend on the reason behind the compensation.
Personal injury settlements can be:
- Taxable
- Non-taxable
- Both taxable and non-taxable
In general, most personal injury settlements resulting from physical injuries that one has not deducted in a previous tax return are non-taxable. If the physical injury results in mental anguish, the emotional injury is also considered non-taxable. For example, if someone becomes injured in a work accident and they develop depression as a result of not being able to work, they may be compensated for mental anguish since it was directly caused by the physical injury.
Though this is generally true, the IRS ultimately has the right to decide whether your settlement qualifies as non-taxable income based on your case’s details.
What Parts of a Personal Injury Settlement May be Taxable?
The details of your case play an important role in taxation.
To better understand what portions of your settlement may or may not be taxable, consider the common parts of a settlement, and how the IRS qualifies them. These will help determine their tax status.
Taxable Income and Medical Bills
There are two rules when you are looking to see if your settlement is taxable.
1) Personal injury settlements that result from physical injuries and illnesses are usually non-taxable. They are often only taxed by the IRS if the settlement intends to replace your income.
2) Under tax laws, if you’ve already claimed the medical deductions due to the injury or sickness of your settlement, your settlement becomes taxable. The reason is that you have already benefited from that money on a previous tax return.
Punitive Damages
Punitive damages are awarded at the discretion of the court. Punitive damages are set by a judge or jury to punish the defendant for outrageous or harmful conduct. Punitive damages are almost always taxable.
Courts use punitive damages as punishment, especially in large, publicized cases. Harmful behavior that is unacceptable in the community is one reason judges award them.
Taxation occurs even if the punitive damages result from or are related to physical injury or illness. Punitive damages fall under the heading of other income on your tax return.
To make the process of filing easier, ensure your lawyer looks at the division of the settlement. How much is compensatory, and how much is punitive?
Settlement Interest
Suppose you invest some or all the amount you received from your settlement. The interest will usually always be taxable interest income.
Emotional Distress
Emotional distress, or mental anguish, is defined as the suffering caused by an experience such as a physical injury.
Whether the award is taxable depends on whether it relates to the subject of the settlement.
If you become mentally anguished due to the direct result of a physical injury, your compensation is generally non-taxable. In this case, the courts may treat emotional distress the same as the rest of the physical settlement.
How Much Tax Should I Expect to Pay on a Personal Injury Settlement?
All or a part of your settlement may be taxable. The IRS considers the following to be “ordinary income” for tax purposes, and by law, you must report them when filing your taxes:
- Interest paid on the amount of your settlement
- Emotional distress not related to physical injury
- Punitive damages
- Attorney fees where the underlying recovery is included in gross income
- Awards for non-injury claims, like a breach of contract
Because parts of your settlement may be taxable without your knowledge, it’s best to inquire with a personal injury lawyer. They will be able to explain all the relevant considerations and help you minimize your tax burden.
Personal Injury Settlement Tax Tips
Below are some tips that may help you keep your taxes low.
- Before the settlement, consider what you wish to receive and itemize your settlement. This will help you and the IRS identify taxable income.
- After the settlement, set awards stemming from physical injuries aside.
- You may be able to divide the settlement into payments over a longer period of time. This can reduce the owed tax on specific taxable portions of the settlement.
- Consult a professional about investments made with the monetary awards of the settlement.
- Speak with the IRS, if necessary. This will help you understand your tax obligations and avoid penalties.
An experienced lawyer and a knowledgeable tax accountant can help you navigate this complex issue. If you’re suffering from personal injury, you don’t want heavy fines due to not understanding your tax responsibilities. You should consult an experienced lawyer and tax accountant before or immediately after receiving any compensation from your personal injury settlement to avoid any future complications when filing taxes.
