How Personal Injury Settlements are Taxed: Avoid Costly Surprises from the IRS

Personal injury compensation may be subject to state or federal taxes. Here’s what you need to know about taxes on injury settlement money.

Most personal injury cases are settled out of court. A few cases go to trial, sometimes resulting in a huge jury verdict in favor of the injured party.

Whether you settled directly with the insurance company or beat the at-fault party in court, you may be left with a tax liability for all or part of your total settlement amount.

Here we reveal when your medical costs, pain and suffering, lost wages, and other monetary awards are exempt from taxation, and when you’ll have to pay.

IRS Tax Rules on Injury Settlements

The Internal Revenue Service (IRS) will have access to your settlement information. In many cases, the insurance company will submit a 1099 tax form to the IRS to report the amount of compensation paid to settle your personal injury claim.

Federal tax law 26 USC 104 governs compensation for injuries or sickness.

Your settlement check and the accompanying release form may not show a breakdown of the compensatory damages included in your injury compensation. Insurance companies usually pay out one lump sum and leave it to you to allocate the different amounts.

IRS Rules on Settlement Taxability state, in part:

“If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income.

BUT, if you receive a settlement for personal physical injuries or physical sickness, you must include in income that portion of the settlement that is for medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit…

The proceeds you receive for emotional distress or mental anguish attributable to a personal physical injury or physical sickness are treated the same as proceeds received for personal physical injuries or physical sickness above.

BUT, if the proceeds you receive for emotional distress or mental anguish do not originate from a personal physical injury or physical sickness, you must include them in your income.”

It’s up to you to accurately disclose all taxable amounts of your injury settlement and pay the taxes accordingly. Failure to report taxable 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.

Every personal injury settlement is different. Consult a tax professional for specific financial advice.

Taxable Income and Wages

If you lost time from work while recovering from your injuries, your personal injury settlement would include an amount to reimburse your lost wages.

You are required to disclose all income when filing your annual income taxes, including the “lost wages” portion of your injury compensation. The government expects you to pay income taxes, regardless of who paid your wages.

However, you need to know when the IRS counts other types of settlement compensation as “ordinary income” for tax purposes, including:

  • Interest paid on the amount of your settlement
  • Punitive damages
  • Awards for non-injury claims, like a breach of contract
  • Attorney fees where the underlying recovery is included in gross income

Punitive Damages

Punitive damage awards are taxable, although most injury settlements won’t include them. Punitive damages are awarded in high-dollar lawsuits, like defective medical device cases, to punish corporate wrongdoers.

Other Tax Issues

Property Damage Payments: Compensation paid for vehicle repairs, or to repair or replace damaged personal items is not generally taxable.

State Taxes: 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.

Marketplace Healthcare Coverage: If you are enrolled in a health insurance plan with a tax credit to offset your premium, your premium tax credit eligibility may be affected by an increase in taxable income. Visit Healthcare.gov for more information about healthcare and your federal taxes.

When are Medical Expenses Taxable?

All injury claim settlements include reimbursement for medical expenses. Strictly speaking, this money is not taxable. Compensation for medical expenses only becomes taxable if you used those expenses for a tax deduction on your prior years’ tax returns.

Qualifying medical expenses are:

“[T]hose 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.”

Previously Deducted Medical Expenses

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 injury settlement, think about whether you’ve already taken a tax deduction for those medical costs.

If you used the costs of your injury treatment to count toward a medical tax deduction on a previous year’s tax return, even if you filed jointly with your spouse, you may have to treat that portion of your settlement money as income.

Why Does the IRS Tax Medical Expenses?

Let’s say 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.

Compensation for previously deducted medical costs is considered income because you’ve already had the benefit of a tax reduction for those amounts.

If you haven’t deducted those medical expenses on a previous tax return, then the amount paid to compensate you for those costs is not taxable.

Workers’ Comp Benefits Are Not Taxable

You don’t have to pay any income taxes on workers’ compensation benefits you receive for a work-related sickness or injury, so long as the benefits are paid out under your state’s workers’ compensation law. As a general rule, workers’ comp death benefits to survivors are also tax-free.

If you go back to work under limitations, the wages earned will be taxable.

Compensation paid from third-party claims outside of workers’ comp will be treated as any other kind of settlement for tax purposes.

Beware of Taxes for Emotional Distress

Taxing authorities differentiate between pain and suffering awards associated with physical injuries and compensation for emotional distress that is not linked to physical harm.

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 physical injury. The physical and the emotional are two parts of the whole loss. Any related compensation is not taxable.

Compensation for emotional distress is taxable when it’s not directly related to a physical injury.

Physical symptoms of emotional distress, like headaches or vomiting, don’t count as a physical injury, although compensation for your medical bills to treat those symptoms is not taxable.

IRS Description of Emotional Distress:

“If the emotional distress is due to a personal injury that isn’t due to a physical injury or sickness (for example, unlawful discrimination or injury to reputation), you must include the damages in your income, except for any damages you receive for medical care due to that emotional distress. Emotional distress includes physical symptoms that result from emotional distress, such as headaches, insomnia, and stomach disorders.”

Aside from emotional distress, any compensation awarded for something other than a physical injury, such as unlawful discrimination, negligent infliction of emotional distress, or injury to character, is taxable.

Attorney Fees and Taxes

Some types of minor injury claims can be handled without an attorney, but for serious injuries, an experienced attorney is needed to get full compensation. Most personal injury attorneys offer free consultations to accident victims.

Most injury victims hire an attorney on a contingency fee basis, meaning their attorney won’t be paid unless they settle their case or win a court verdict. The attorney’s fees are paid out of the victim’s settlement.

It’s easy to think of your “final settlement” as the amount you take home after attorney fees and costs are paid.

However, when the “cause of action” doesn’t involve a physical injury, like a wrongful termination lawsuit, the entire settlement amount may be taxable, including the percentage promised to your attorney. The government can consider the entire award as your taxable income before the attorney is paid.

Fortunately, when you have to include the entire settlement amount as income, your tax preparer can usually claim the attorney fees as a deduction.

It Pays to Talk to an Expert

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 award, set the money aside and talk to a professional.

If you anticipate a large payout, ask your personal injury lawyer about consulting a tax professional before the final settlement agreement is signed. For example, if you expect to be paid years of future lost income, there may be options that will lower your tax burden, such as a structured settlement.

Want to handle it yourself? 

Contact Your Local IRS Office for taxpayer assistance online or over the phone.

Charles R. Gueli, Esq. is a personal injury attorney with over 20 years of legal experience. He’s admitted to the NY State Bar, and been named a Super Lawyer for the NY Metro area, an exclusive honor awarded to the top five percent of attorneys. Charles has worked extensively in the areas of auto accidents,... Read More >>