Generally, compensation for your pain and suffering is not taxable. But, specific portions of your settlement, such as reimbursement for lost wages, may be subject to income tax. Before spending your insurance settlement money, you need to know what portion of it is taxable, and put that money aside.
The federal government will have access to your settlement information. Failure to report a portion of your compensation on your tax return can subject you to the same penalties as any other unreported income. Like it or not, you can't escape federal income taxes.
Your settlement check, and the accompanying release form, may not show a breakdown of the separate amounts for your medical expenses, lost wages, and pain and suffering. Insurance companies usually pay out one lump sum and leave it to you to allocate the different amounts.
Categorizing insurance settlement funds is somewhat subjective, so the Internal Revenue Service traditionally hasn't considered enforcing settlement taxes a priority. However, you should be aware that failing to pay taxes on your settlement proceeds could trigger an audit.
All personal injury settlements include reimbursement for medical expenses. Strictly speaking, this money is not taxable. It only becomes taxable if you deduct those same medical expenses on your tax return. You can only deduct something as an expense if you don't get reimbursed for it.
IRS Code § 213 defines qualifying medical costs as follows:
...those medical expenses incurred to diagnose, cure, treat, mitigate or prevent a disease, or for the purpose of affecting any structure or function of the body."
You only pay taxes if you've already deducted the expense.
A portion of your general medical expenses is tax deductible, but only if you don't get reimbursed for them. If you previously deducted those costs on a recently filed tax return, but later receive settlement compensation to cover those costs, you'll have to pay income tax on that portion of your settlement funds.
In other words, if you deduct those costs on your tax return as an expense, then get paid back for those same costs from the settlement, they're no longer an expense, right?
You may have had no choice but to pay out-of-pocket for medical treatment while your claim was pending. If so, when you receive your lump sum settlement, consider whether you've already taken a tax deduction for those medical costs.
If you've already deducted your treatment expenses on your most recent tax return, set aside at least a third of the total amount of those expenses from your settlement payout, since you'll probably have to pay income tax on the full amount.
Why does the IRS tax these expenses?
According to the IRS, the reasoning is simple. You paid for medical treatment out of your own pocket while your injury claim was pending, and then took the associated tax deduction. When you settled your claim, the settlement included reimbursement from the insurance company for those same medical costs.
That amount is considered income because it's not money to reimburse you for your injuries or pain and suffering. The funds are reimbursement for the money you paid to the medical providers. And since you already deducted that money on your previous tax return, the IRS considers the amount you received in your settlement as "ordinary income."
If you haven't deducted those medical expenses on your previous tax return, then you will be able to keep the total amount specifically representing those costs.
Note: Many states have their own income tax requirements. Check with your state tax authority if any part of your settlement is taxable, especially the portion paid for lost income. Even better, have an experienced accountant review your tax return.
Most bodily injury settlements include reimbursement for lost income. Chances are your settlement includes some amount for your lost wages. You'll have to pay income tax on that amount, the same as you would for any employment earnings. The IRS considers it "ordinary income."
To be safe, put aside a third of the total amount of your reimbursement for lost income. Or, if you already know your income tax rate, set aside that percentage so it's available when you file your tax return.
The IRS will find out about your settlement, and it's very easy for them to determine the amount of compensation paid to you for lost income. To be in compliance with federal law, you must list the amount of your reimbursed income on your federal tax return.
A physical injury can be diagnosed in medical terms, but the pain and suffering associated with that same injury cannot. Nevertheless, that emotional suffering is as real as the physical injury. The physical and the emotional are two parts of the whole loss. Any related compensation is not taxable.
Keep in mind, if you were awarded compensation for something other than a physical injury, such as unlawful discrimination or injury to character, that money is taxable. Check IRS Publication 525, the section on Court Awards and Damages for more specific information.
The IRS does not consider punitive damages the same as pain and suffering or emotional distress. You probably don't have to worry about this however, since the majority of personal injury settlements do not include punitive damages.
If you were awarded punitive damages as part of your settlement, that amount is considered taxable income, and should be reported on your 1040.
Tax attorneys and certified public accountants can spend their entire careers interpreting sections of the Internal Revenue Code. If you have any questions about paying taxes on your settlement, talk to a professional.
You can also contact the IRS directly. Publication 525 gives a complete breakdown of taxable and non-taxable income. If you want to speak with an IRS representative about income tax obligations, especially in regards to your bodily injury settlement, you can call them at 1-800-829-1040, or visit your local Taxpayer Assistance Center.
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