The median award for a personal injury settlement is around $31,000, though the amount can vary significantly according to the type of case [1].
While personal injury settlements offer you the funds you need to recover, it’s crucial to understand the potential tax liability. Whether you must pay tax on your settlement depends on the circumstances of your case.
What is a Personal Injury Settlement?
A personal injury settlement is an agreed-upon amount provided to a victim after insurance negotiation or, in some cases, after a personal injury lawsuit. It is meant to reimburse medical expenses and lost wages associated with physical injury. Sometimes, it also compensates for non-economic damages, like pain and suffering or emotional distress.
Working with personal injury attorneys can improve your chances of receiving a settlement that covers both physical injuries and emotional pain. If your case goes to trial, the court may award compensatory and punitive damages.
Compensatory damages offer financial support for injury-related medical expenses and other needs, similar to what you could receive from an insurance company or workers’ compensation.
Punitive damages punish the defendant for gross negligence. They may be more common in wrongful death suits, occupational-related physical sickness suits, or cases where the personal physical injuries were very severe.
The General Rule: Tax-Free Settlements
Personal injury settlements are generally considered non-taxable income by the Internal Revenue Service, just like retirement benefits or Social Security. This principle means you won’t need to pay federal taxes on your settlement, though your typical tax bracket still applies to other income.
However, there are some exceptions in a personal injury case that you may need to pay taxes on at the state or federal level.
Exceptions and Taxable Elements
While you generally will not owe taxes on personal injury settlements, some aspects are not tax-exempt. It’s crucial to consult with a professional who can determine what rules apply so that you do not run afoul of the federal government.
Punitive Damages
Punitive damages awarded in personal injury lawsuits to punish the defendant are part of your annual gross income, which is taxable. The IRS views punitive damages as additional compensation rather than reimbursement for actual losses related to your physical injury.
Unlike non-taxable settlements, which cover expenses directly related to your accident, these don’t correlate to medical bills or lost wages associated with a personal physical injury.
Interest on Settlements
Personal injury settlements may accrue interest in several ways. If the case has gone to trial and there is a gap between when the jury awards the settlement and when you receive the funds in your bank account, interest can accrue.
If the defendant does not pay you promptly, then they must pay interest on the outstanding amount. Lastly, structured settlements may accrue interest through annuities.
Like interest on investments, the interest in personal injury settlements is considered taxable income. You’ll need to calculate the interest paid on your income taxes.
Emotional Distress and Mental Anguish
Generally, paying medical bills or lost income does not have any tax burden, but tax rules may differ for other elements of a settlement. A personal injury settlement related to emotional distress or mental anguish may or may not be taxable income, depending on how these elements are connected to a physical illness or injury.
Under the federal tax code, compensation arising from physical personal injuries is tax-free, which would include emotional distress or mental anguish that is directly linked to this bodily injury.
As an example, people who are severely injured in car accidents can claim that their mental distress came from their injuries, in which case they would not have to pay tax on this element of a settlement.
On the other hand, surviving family members in a car accident who were not injured but who claim mental distress due to losing their loved one may have to pay taxes on this part of the personal injury settlement.
Reimbursement of Previously Deducted Medical Expenses
You may still have to pay taxes on certain compensatory damages depending on whether you previously claimed a tax break for them, specifically medical costs.
It is common to take a tax deduction for medical bills accrued throughout the year on your tax return. If you were reimbursed for deductions you made in a previous tax year, you may have to repay this tax benefit.
Is a Personal Injury Settlement Taxable?
Personal injury settlements are not always taxable at the federal level, but state tax rules can differ, making it crucial to consult with tax professionals before filing your return.
Variations in State Laws
Personal injury lawsuit settlements may be taxed at the state level, depending on the specifics of the case. In most cases, punitive damages and compensation not directly related to a physical injury must be claimed on a state tax return.
Importance of Consulting a Tax Professional
A professional tax preparer can help you prepare your tax forms for personal injury cases, including dividing up the different forms of compensation to see what is and is not taxable income. They will also be familiar with the specific tax implications for your state.
Structured Settlements and Tax Considerations
A structured settlement provides periodic payments, typically monthly or quarterly, so you have consistent funds to pay for your needs. It is also possible to hold off on receiving your settlement for a few years so that you have that money later, such as during retirement.
In contrast, a lump sum settlement is paid out all at once. You and your lawyer may be able to decide how you want your settlement.
Tax Implications of Structured Settlements
In general, structured settlements are tax-free, providing dependable income for months or years. However, any interest will be taxable, just as with a lump sum settlement.
The specific tax treatment can depend on factors like the type of damages being paid, how the agreement is worded, and whether the settlement includes punitive damages or compensation for non-physical injuries.
You may work with a settlement broker, who will help advise you on how to structure your settlement to minimize or eliminate taxes on received funds.
However, working with a tax attorney before signing a structured settlement is crucial to receive favorable terms and understand the details of your settlement. They can advise you on the different factors that go into the settlement.
Seeking Legal and Financial Guidance
When asking, “Are personal injury settlements taxable?” there are broad answers. Still, many of the individual facets will depend on the specifics of your case, including how much of the settlement is for direct physical injuries and how much is from punitive damages.
As such, it’s crucial to work with professionals familiar with these settlements who can help you make the best choices for your needs.
The Role of a Personal Injury Lawyer
A personal injury lawyer can help you navigate the potential tax implications of your settlements and negotiate favorable terms to cover your needs. Here’s how they can assist:
- They can explain how different settlement structures might affect your tax liability, helping you make informed decisions.
- Your lawyer can negotiate with the opposing party to structure the settlement to minimize your tax burden, such as allocating more of the settlement to non-taxable categories.
- They often work with tax professionals and financial advisors to ensure all aspects of your settlement’s tax implications are considered.
- Your lawyer can help you consider the long-term financial impact of your settlement, including how it might affect your future tax situations, and avoid unexpected tax liabilities.
Consulting a Tax Professional
Your tax return may be more complicated after you receive a settlement, so it’s helpful to consult with a tax firm to help you navigate your return. These professionals can assess the specifics of your settlement to determine what is or is not taxable.
They will ensure that you stay aware of the tax code and will work to minimize your liabilities so you can save more of your money for your other needs. This insight can be especially helpful if any interest was paid out on your settlement, such as a delay between the jury verdict and receipt of the funds.
Book a Personal Injury Case Evaluation!
Navigating the tax implications of personal injury settlements can be complex, but you don’t have to face it alone. Rosenfeld Injury Lawyers has the expertise to help you understand and optimize the tax aspects of your settlement.
We have helped thousands of clients achieve millions of dollars in settlements. We work on a contingency fee basis, meaning that our legal fees are deducted from your settlement rather than paid out of pocket.
Contact us today for a free consultation at (888) 424-5757 or fill out our contact form.
References: [1] Forbes