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If you are harmed by someone’s negligence or an intentional wrongful act, you can file a civil lawsuit to recover compensation for your losses. You may receive payment for monetary damages either as a result of prevailing in your lawsuit or from an out-of-court settlement.
When you receive compensation, you may be wondering, are personal injury settlements taxable? After all, typically you receive a large sum of money from an injury settlement–and usually the government takes a cut when you get paid.
This guide explains the rules for how taxes are handled when you get personal injury compensation.
What Is a Personal Injury Settlement?
If someone hurts you, you are entitled to make a claim to recover compensation so you can be “made whole” for your damages. You can pursue a civil case in court and the court will award you damages if you prove your claim. Or you can negotiate a settlement.
A personal injury settlement is paid as a result of those negotiations. Most often, you negotiate with an insurer such as an auto insurer, homeowner’s insurer or malpractice insurer representing the person or company that hurt you.
The insurer (or defendant who hurt you) will offer you a set amount of money in exchange for giving any further claims. This money is your personal injury settlement. Your settlement (or the damages awarded in a lawsuit) typically compensates you for:
- Medical bills incurred to treat injuries
- Lost wages if you missed work or can’t work due to your injuries
- Pain and suffering and emotional distress your injuries cause
A personal injury settlement can be worth tens of thousands of dollars or even millions of dollars. That’s why answering the question, are personal injury settlements taxable, is so important.
Are Personal Injury Settlements Taxable on the Federal Level?
If you wonder whether lawsuit settlements are taxable, the good news is that personal injury settlements are not taxable on the federal level. According to IRC Section 104(a)(2), damages from personal injuries are tax-exempt, except for punitive damages. This means the IRS will not take any portion of your compensatory awards.
The federal government does not tax your settlement money since the funds received are intended to compensate you for losses that you endured. This is true both for actual economic damages (such as medical bills and lost wages) and for non-economic damages such as for pain and suffering and emotional distress.
However it is important to note that pain and suffering and emotional distress are not taxable only if there is a physical injury. If a dog lunged at you and caused you to develop PTSD but you were not physically harmed, damages for emotional distress would be taxable.
Economic damages are not taxed because you are simply recouping lost funds while non-economic damages are not taxed because they are meant to help make you whole for losses that you can’t get direct compensation for, such as pain you experience.
Since these are compensatory damages, the government assumes you’ve experienced a loss equal to the money you received and thus you don’t have taxable income from your settlement.
Are Personal Injury Settlements Taxable on the State Level?
Some states also charge income taxes when you earn money, which are separate from federal taxes charged by the IRS and which are governed under different rules.
Although state tax rules differ from place to place, generally, states also do not tax personal injury settlements. To cite just one example, the Washington State Department of Revenue says that legal settlements for personal injury are not taxable in the state.
States also believe this money is intended to compensate you for losses. It is not income or a windfall, but rather money meant to pay you back for harm you endured.
When are Personal Injury Settlements Taxed?
If you have received lawsuit compensation and wonder, “Are personal injury settlements taxable?” the answer is that it depends. Certain damages may be taxable, including:
- Awards for lost income
- Punitive damages
- Previously deducted medical costs
- Interest on your settlement
According to the IRS, punitive damages count as income, which means they are subject to taxation just as any other income would be. You may also owe taxes on the portion of your settlement related to medical expenses, but only if you previously deducted medical costs as a loss on your tax return. When you receive a settlement, consider contacting a tax professional who can identify your specific tax liabilities.
Possible Exception for Medical Expenses
The answer to the question, are personal injury settlements taxable, is a bit more complicated than it might seem, though.
That’s because there’s certain situations where you might have to declare some of the income from your settlement on your federal and/or state tax return. This could occur if you took an itemized deduction for medical bills related to your injury in the years leading up to your settlement.
If you claimed a tax deduction for medical expenses and you then receive compensation for those expenses, you are required to declare income from the settlement that was meant to compensate you for the expenses you took a deduction for–if that deduction provided you with a tax benefit
For example, if you took a tax deduction for $10,000 of injury-related expenses and you receive a settlement that includes payment for those expenses, you would need to declare up to $10,000 of your settlement as taxable income.
Are Punitive Damages Taxable?
Although most personal injury compensation is not taxable, there is an exception for punitive damages. These are not awarded in every personal injury case but may be awarded in circ*mstances where a defendant’s wrongdoing was egregious.
Punitive damages aren’t meant to compensate victims but are instead intended to punish defendants and deter future bad behavior. Since this money isn’t making you whole from prior losses, you may be taxed on the money you receive. The exception is if the claim was for wrongful death. In wrongful death cases, where state law provides only for punitive damages, the IRS considers these damages not taxable.
If you receive punitive damages, talk with your personal injury lawyer as well as with a tax attorney to determine whether your damages are considered taxable or not.
Are Wrongful Death Damages Taxable?
In situations where negligence or intentional wrongdoing result in a death, the estate of the deceased or surviving family members can make a wrongful death claim to recover compensation.
Damages for a wrongful death claim usually include medical bills incurred prior to death, lost wages the deceased would have earned had the injury not occurred, pain and suffering, emotional distress and loss of the deceased’s companionship. Since wrongful death is, in essence, a personal injury case in which the plaintiff died, the question “is a personal injury settlement taxable?” may arise.
In most cases, these economic and non-economic damages for wrongful death are also not taxable because they are meant to make you whole from a wrong.
An attorney can provide assistance in both personal injury and wrongful death cases to help you maximize your settlement and understand your tax obligations when you are compensated for harm.
Do I report a personal injury settlement to the IRS?
Per IRC Section 61, the IRS considers all amounts from any source as income. This can include personal injury settlements, regardless of whether they are taxable or not. Generally, you should report all taxable income, including punitive damages, interest on your settlement and others. You may have to report non-taxable incom, too, depending on state and federal regulations and your specific circ*mstances.
Note that merely reporting your personal injury settlement on your annual tax return doesn’t necessarily mean you have to pay taxes on it. Since tax reporting requirements can change annually and vary from one state to another, contact a tax professional to understand your reporting obligations.
Frequently Asked Questions (FAQs)
What types of lawsuit settlements aren't taxable?
In general, economic and non-economic damages for physical injuries are not taxable. This means you do not have to pay taxes on compensation you receive after a car accident, slip and fall, medical malpractice incident or other situation where someone is held liable for physically harming you.
How do I report settlement income on my taxes?
In many cases, a personal injury settlement is not taxed. If you do receive a taxable court settlement, you will likely receive a Form 1099-MISC. You report the information from this form on your tax returns in the Other Income box on your tax forms. Consult with a tax preparer if you need help.
Are compensatory and punitive damages taxable?
When you’re looking for an answer to “are lawsuit settlements taxable?” remember there is a distinction between compensatory and punitive damages. Compensatory damages are intended to compensate you for the harm you experience due to someone’s intentionally wrongful or negligent behavior. If you receive compensatory damages as a result of a physical injury, the money is generally not taxable. However, punitive damages are intended to punish the defendant rather than to compensate you. This is taxable except in wrongful death cases.
Is a pain and suffering settlement taxable by the IRS?
Non-economic damages, such as pain and suffering, are generally not taxable because, like economic damages, they are intended to make you “whole” again after suffering a personal injury.
However, there can be exceptions when you might have to pay taxes on pain and suffering. For example, if the pain and suffering damages are not related to a physical injury or reimbursem*nt of medical expenses for pain and suffering, they may be taxable.
