Do You Have to Pay Taxes on a Personal Injury Settlement?
Going through a personal injury lawsuit and coming out victorious in a settlement can be an amazing experience that leaves you feeling satisfied that you’ve received justice. Many personal injury settlements come in the form of monetary compensation, but it is a common misconception that all settlement money is tax-free.
There are taxable and non-taxable portions of settlement amounts, along with IRS rules you need to follow. Since settlement checks can take 4-6 weeks to arrive, learn these taxable portions and the best way to minimize your taxes so that you can maximize your reward when it comes.
Are Personal Injury Settlements Taxable?
The good news for you is that the majority of personal injury settlement amounts are non-taxable under IRC Section 104(a)(2) so long as they are not from punitive damages and are related to physical injuries or sickness. Punitive damages, as background, are damages meant to punish the defendant, whereas compensatory damages are designed to make you whole and are based directly on the scope of your injuries.Non-Taxable Portions of a Settlement
As outlined, most compensatory damages will not be taxable, according to the IRS. The non-taxable portions of your settlement, therefore, are typically inclusive of the following:1. Medical Expenses: Compensation for medical bills is generally tax-free unless deductions were previously claimed.
2. Pain and Suffering (Physical Injuries): Emotional distress directly tied to a physical injury is usually non-taxable.
3. Lost Wages (Physical Injury Cases): Reimbursement for income lost due to injury is typically tax-free.
4. Property Damage: Compensation for vehicle repairs or other damaged property is usually not taxed, but the specific rules can vary by state.
Are There Taxable Portions of a Settlement?
As alluded to, there are portions of a settlement that may be taxable. The first, mentioned earlier, is any type of punitive damage that was meant to punish the defendant rather than make you whole based on your injury. This could be a blanket fine the defendant was forced to pay on top of compensatory damages or something similar.Additionally, if your personal injury case was solely on the basis of emotional distress with no physical harm, then the IRS considers the whole sum taxable. Interest in settlement amounts that have been accrued and previously deducted medical expenses (typically in past tax returns) will also require tax payments in most cases.
How the IRS Handles Mixed Settlements
The IRS handles mixed settlements by simply demanding taxes on the taxable portion. This is why specifying in your settlement agreement that specific damage allocation be listed is crucial. This will help to reduce your tax burden by not allowing the IRS to call some of a banket sum taxable when, in reality, it wasn’t.You will need to disclose some type of breakout on your tax return when listing your other income in order to show this, which is why requesting the breakout at the time of settlement is recommended. If you are ever unsure of how the IRS will treat your situation, don’t hesitate to reach out to a tax professional who can consult with you and provide answers to your questions.
How to Minimize Taxes on a Personal Injury Settlement
Nobody wants to receive a massive settlement only to realize that most of it needs to go towards taxes because they didn’t request proper classification in advance. To that end, consider working with a tax professional when organizing your settlement agreement so that you can properly categorize your imminent settlement funds.Ensure that any settlement agreement you draft clarifies tax-free vs. taxable portions along with the reasoning too. If your settlement amount is heavily taxable, consider requesting that the settlement be structured over time through annuity payments in order to spread out your tax liabilities. You should also keep records of all your medical expenses and prior deductions to avoid any issues with the IRS when you do submit your taxes.
Properly fulfill your tax obligation from your settlement
Most personal injury settlement award amounts are non-taxable, given that the damages are compensatory and related to physical injuries a lot. However, in cases where the lawsuit was about emotional distress or if there were many punitive damages, it’s worth consulting with a tax expert or your lawyer to clarify what your tax obligation is. Always review settlement agreements carefully in order to avoid unexpected tax liabilities that you may be unaware of as this can reduce the impact your settlement amount has.Do You Need An Attorney?
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Posted - 03/05/2025
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