If you received a personal injury settlement, the full amount of the accident settlement is non-taxable if you did not take itemized deduction for the medical expenses related to your injuries. This means you do not need to include an accident settlement when declaring income.
Some components of personal injury settlements are taxable, though. These include pain and suffering, lost wages, emotional distress damages, and punitive damages.
When you receive proceeds for lost earnings in a car accident settlement, that compensation is taxable because wages are taxable. Compensation for medical bills only becomes taxable if you included those expenses for a tax deduction on the previous year’s tax returns.
Emotional distress compensation is taxable, but damages for physical sickness are not taxable.
How Much Tax Will I Pay On My Settlement?
Per the tax code, only the damages you can claim for physical sickness or physical injury are not taxable. If you are awarded compensation for emotional distress or punitive damages, that money becomes taxable.
Taxes are predicated on the origin of claim. This means if you are suing for physical injuries directly caused by the negligence of another party, those proceeds would not always be considered income.
Attorney fees account for your income. If you are suing for emotional distress and you receive an award of $100,000, you might pay your lawyer $40,000 in fees. Your total income, nevertheless, is still $100,000.
Is it Possible to Avoid Paying Tax on a Settlement?
Often, your dispute and settlement will involve more than one legal issue, meaning you may need to pay taxes on some elements, but not on others.
Medical expenses are tax-free, even if the payments are made to counselors, psychiatrists, or other mental healthcare professionals. There is some gray area between physical and emotional care, and any confusion will be clarified during the litigation process.
If you are suing for punitive damages, whether for an emotional or physical-related claim, those proceeds will be taxable. Those damages are not intended as compensation for your loss.
What Forms of Compensation Are Taxable?
Most judgements and settlements are only intended for general damages and compensatory damages. Those classifications of damages are to compensate you for the medical expenses, lost earnings, and pain and suffering directly arising from your accident injuries.
In a typical settlement, then, you receive only damages for medical expenses and physical injuries, with most of that amount not subject to taxes.
Most people seek settlements from the at-fault driver of a car accident after suffering physical injuries. The costs of these injuries can easily run beyond $10,000. In the event of serious injuries, costs incurred can amount to hundreds of thousands of dollars.
You can receive compensation for the following out-of-pocket medical expenses:
- Over-the-counter medication
- Prescription drugs
- Doctor’s visits
- Hospital stays
- Assistive devices (wheelchair or crutches)
Damages for medical care are typically based on the following:
Medical bills paid out of pocket
Future anticipated medical treatment
The amount of compensation you receive for this medical treatment is not included in your income according to the IRS, meaning it is not taxable.
The cost of physical injuries can go beyond the cost of medical care. Injuries also often cause demonstrable pain and suffering. If you suffer serious injuries in a car accident, you should receive at least some money as compensation for your pain and suffering.
The amount of pain and suffering compensation you will receive depends on the scope and severity of your accident injuries.
Since pain and suffering damages stem from physical injuries, the IRS does not classify this compensation as taxable. In the same way as compensation for medical bills, compensation for pain and suffering is not taxable.
As a general rule, settlements or judgments intended as compensation for lost income are taxable. The reasoning for this is that your original income – had you not suffered the loss of income – would have been taxable. Accordingly, any compensation intended to replace that lost income will be taxable.
When a judgment or settlement includes compensation for other losses in addition to lost income – medical bills, for instance – you are still liable to pay tax on any portion attributable to lost income.
If you receive compensation for damage to property or your vehicle in a settlement, this money will not be taxable, whether you spent money on repairs or to rent a vehicle after the accident. Here, you are being reimbursed for out-of-pocket expenses, so those expenses cannot be taxed as income.
Punitive damages and interest
Punitive damages are rarely included in a car accident judgment or settlement. This category of damages is typically intended to deter future poor behavior by punishing the defendant. If you receive this type of damages, they will almost always be taxable.