Reaching the end of a personal injury case, especially one resulting in a substantial settlement, often brings a sense of relief and closure. The stress weighing on you may finally lift, allowing you to breathe easier.
If you got help from a personal injury attorney, they likely worked to maximize your compensation. Your bills are covered, and you’ve been properly compensated for your injuries and property loss. With justice served, you might feel a renewed sense of optimism.
However, when tax season approaches, an important question arises: “Are injury or accident settlements taxable?” Do these settlements count as income subject to taxation? Are you obligated to report them to the IRS? Let’s talk about this important topic and provide some clarity.
Tax Laws and Your Personal Injury Settlement
Prior to 1996, the majority of personal injury settlements were tax free. It didn’t matter if they were for physical injuries or emotional ones; they were not taxed. Tax laws have changed though, and while physical injury settlements are non-taxable for the most part, there are some exceptions.
The Internal Revenue Service (IRS) does not define the money that you are awarded for a personal injury claim or lawsuit as wages, salaries, or tips. Instead, it is considered “compensatory” money, meaning it is money intended to compensate you for a loss. While most people believe that income deemed compensatory is automatically non-taxable, this is not entirely accurate according to IRS rules. There are some instances where that settlement income could be taxed, and failure to properly identify your income and file your taxes accordingly could result in you taking a significant financial hit.
What Portion of a Personal Injury Settlement is Not Taxable?
The IRS has provided detailed information regarding what can and cannot be taxed in regard to a personal injury settlement or jury award. The money from these cases is specifically excluded from being any type of taxable income when it is intended to compensate you for:
1. Physical Injuries
Compensation for physical injuries is generally not taxable. This includes payments for medical treatments, rehabilitation, physical therapy, and any other costs directly related to treating the physical injury. It may also cover compensation for long-term effects or disabilities resulting from the injury.
2. Lost Wages Resulting From Your Physical Injuries
If you could not work due to your physical injuries, any compensation you receive for those lost wages is typically not taxable. This applies to both past lost wages (from the time of injury until settlement) and future lost wages (if your injury affects your ability to earn in the future).
3. Emotional Distress Caused By Your Physical Injuries
Compensation for emotional distress is not taxable when it’s directly related to your physical injuries. This could include anxiety, depression, insomnia, or PTSD that developed as a result of the physical trauma. However, it’s important to note that emotional distress compensation that’s not tied to physical injuries may be taxable.
These non-taxable elements form the core of most personal injury settlements. However, it’s important to have the settlement agreement clearly specify the purpose of each payment to avoid potential tax issues later.
Additionally, while these components are generally not taxable at the federal level, state tax laws may vary. It’s always wise to consult with an attorney familiar with your state’s regulations.
Exceptions to Non-Taxable Personal Injury Settlements
The decisions you made regarding what you did with the money from your settlement as well as how you filed your taxes in the past can weigh heavily on what you may owe the IRS on your settlement.
For instance, if you already received any type of tax benefit related to your case then you are not qualified to take advantage of or receive any additional tax benefits. This can include deducting on a previous year’s income tax return any out of pocket costs you may have paid for your medical care related to the accident. While that is perfectly legal, you cannot double dip. This means that since you received compensation for those expenses, you must pay back to the IRS what you deducted on that previous return. It is considered “other income” on the 1040 tax for – and you need to report it.
Is Interest Earned on a Settlement Taxable?
Interest earned on a settlement or money recovered from a personal injury case is generally taxable, even if the settlement itself is tax-exempt. You must report this interest on your Form 1040 as “other income” when you file your taxes.
The requirement applies to various types of interest, including that which accrues between the settlement agreement and the payout, as well as interest earned if the settlement was placed in an interest-bearing account.
Typically, you’ll receive a Form 1099-INT from the defendant or their insurer detailing the interest paid. This form is vital for accurate tax reporting and should be kept for your records. You usually must report this interest in the tax year you receive it, even if your settlement spans multiple years.
While federal tax law is clear on the taxability of settlement interest, state tax laws may vary. Some states might have different rules or exemptions for settlement interest, which could affect your overall tax liability. In some cases, especially with long-running settlements, it may not always be immediately clear what portion of a payment constitutes interest.
Given the specific nature of settlement interest and taxation, seeking professional guidance is advisable if you’re unsure about your reporting obligations.
Consulting your attorney can ensure you correctly handle the tax implications of your settlement interest. They can provide personalized advice based on the specifics of your case and help you navigate the tax code.
Remember, you must properly report settlement interest to avoid issues with tax authorities.
Are Punitive Damages Taxable?
Punitive damages are a specific type of compensation awarded in civil lawsuits, designed to punish defendants for particularly egregious conduct and deter similar behavior in the future. Unlike compensatory damages, which reimburse plaintiffs for actual losses or injuries, punitive damages are generally taxable.
The tax treatment of punitive damages is as follows:
- Taxability: Punitive damages are typically subject to federal income tax, even when awarded in cases involving physical injury or illness where compensatory damages might be tax-free.
- Reporting: Recipients must report punitive damages as “Other Income” on Form 1040, subjecting them to ordinary income tax rates.
- Exceptions: There are very few exceptions to the taxability of punitive damages. One rare exception exists for certain whistleblower cases, but this is uncommon.
- Timing of tax liability: Taxes on punitive damages are usually due in the year they are received, potentially creating a significant tax burden for large awards.
- Estimated tax payments: Recipients of substantial punitive damage awards may need to make estimated tax payments throughout the year to avoid penalties for underpayment of taxes.
- State taxes: In addition to federal taxes, punitive damages may be subject to state income taxes, depending on the recipient’s location.
- Deductions: Legal fees associated with obtaining punitive damages may be deductible, potentially offsetting some of the tax burden. However, rules for deducting legal fees can be complex.
- Structured settlements: In some cases, structuring the payment of punitive damages over time may help manage the tax burden.
- Impact on other benefits: A large punitive damage award could affect eligibility for certain income-based government benefits or tax credits.
- Documentation: Maintain detailed records of any settlement or judgment, including a clear breakdown of compensatory versus punitive damages.
Given the complexity of tax law surrounding punitive damages, consult a tax professional or an attorney. They can provide guidance tailored to specific situations and help navigate potential tax implications.
Common Tax Pitfalls in Personal Injury Cases
With personal injury settlements and taxes, never fall into common traps. Being aware of pitfalls can help you avoid costly mistakes and ensure you’re complying with tax laws.
Here are some of the most frequent tax-related errors in personal injury cases:
- Misclassifying Settlement Components: Not all parts of a settlement are treated equally for tax purposes. Failing to properly categorize compensation for physical injuries, emotional distress, punitive damages, and interest can lead to incorrect reporting and potential audits.
- Overlooking State Taxes: While federal tax laws are uniform, state tax laws can vary significantly. Some people focus solely on federal taxes and forget to consider their state’s specific rules regarding personal injury settlements.
- Ignoring the Medicare Secondary Payer Act: If you’re a Medicare beneficiary, failing to report your settlement to Medicare could result in penalties and affect your future benefits.
- Failing to Account for Attorney Fees: The tax treatment of attorney fees in personal injury cases can be complex. In some cases, you may need to report the full settlement amount as income, even if a significant portion went to your attorney.
- Mishandling Structured Settlements: While structured settlements can offer tax advantages, mismanaging them or prematurely selling future payments can result in unexpected tax liabilities.
- Not Planning for the Alternative Minimum Tax (AMT): Large settlements can sometimes trigger the AMT, potentially increasing your tax burden. Failure to plan for this can lead to a surprise tax bill.
- Neglecting Estimated Tax Payments: If your settlement significantly increases your income for the year, you may need to make estimated tax payments to avoid penalties.
- Failing to Consult Tax Professionals: Personal injury settlements can create complex tax situations. Attempting to navigate these waters without professional guidance often leads to errors.
- Misunderstanding Medical Expense Deductions: If you deducted medical expenses related to your injury in previous years and later receive compensation for these expenses, you may need to report this as income.
- Ignoring Tax Implications of Investment Income: If you invest your settlement funds, the returns on these investments are typically taxable, even if the original settlement was tax-free.
By being aware of these common pitfalls, you can better prepare yourself to handle the tax implications of your personal injury settlement. Remember, every case is unique, and tax laws can change.
Always consult a tax professional and attorney with experience with personal injury settlements to ensure you’re making informed decisions about your situation.
Talk to a Levar Law Injury and Accident Lawyers About Your Settlement Today
If you have been injured in an accident and are seeking compensation or have received compensation and aren’t sure what, if any, part is taxable, let us help.
At the Law Offices of Alan LeVar, our knowledgeable, experienced attorneys will stick with you and help you at every stage of your settlement process, from first filing your taxes to reflect any money you must pay taxes on.
Personal injury cases can confuse you, and the IRS laws are extremely complex. Don’t try to do it on your own. Let us help.
