The General Rule for Injury Settlement Taxes
Injury settlement taxes depend on what the payment is for, and federal law generally excludes damages received on account of personal physical injuries or physical sickness from income. That rule covers most money from a typical car crash or fall claim. Yet some parts of a settlement can still be taxable, such as punitive damages, interest or amounts tied to medical expenses you already deducted. So the wording of the settlement and the nature of the claim both matter.
The Federal Statute
Section 104(a)(2) of the Internal Revenue Code excludes from gross income damages, other than punitive damages, received by suit or agreement on account of personal physical injuries or physical sickness. The exclusion applies whether the money comes as a lump sum or as periodic payments. The text is on the Legal Information Institute site.
Physical is the key word. A claim built on a broken bone, a concussion or a spinal injury usually fits. A claim with no physical injury, such as some employment disputes, follows different rules.
What the IRS Publication Says
The IRS explains the rules in Publication 4345. According to the publication, a settlement for personal physical injuries or physical sickness is generally not taxable if you did not take an itemized deduction for related medical expenses in earlier years. If you did take that deduction, the portion of the settlement that repays those expenses may be taxable to the extent the deduction gave you a tax benefit.
The publication also says that whether settlement money is taxable depends on all the facts and circumstances. Therefore, the IRS may treat two similar looking settlements differently.
Emotional Distress and Injury Settlement Taxes
Emotional distress damages that stem from a physical injury generally follow the same rule as the physical injury damages. So anxiety or sleep problems after a crash that broke your arm usually fall within the exclusion.
However, emotional distress damages that do not originate from a physical injury are generally taxable, according to the IRS. Certain medical expenses for that distress may reduce the amount included. That distinction can matter in claims that mix physical and nonphysical harms.
Punitive Damages and Interest
The federal exclusion expressly leaves out punitive damages. As a result, punitive awards are generally taxable. Interest paid on a judgment or settlement is also generally taxable. For more on punitive claims, see the site’s explanation of the related survival and death rules in wrongful death versus survival.
Lost Wages
People often ask whether the lost wage part of a settlement is taxable. When the lost wages arise from a physical injury claim, they generally fall within the same exclusion as the rest of the physical injury damages. Still, the facts and the settlement language matter. Ask a tax professional how the rules apply to your settlement.
How Allocation Affects Injury Settlement Taxes
Settlement agreements sometimes divide the payment among different categories. The IRS publication says it generally will not disturb an allocation that is consistent with the substance of the settled claims. So the allocation should reflect what the claim was actually about.
Ask your lawyer whether the agreement will include an allocation. Then share a draft with your tax adviser before signing, since changes afterward can be difficult.
Property Damage Payments
Payments for vehicle damage generally reimburse you for a loss. The tax treatment of those payments depends on your basis in the property and other factors. Most people with a personal vehicle never have taxable gain from a repair payment, though unusual cases exist. Ask a tax professional if your payment exceeded what you paid for the vehicle.
Wrongful Death Settlements
Wrongful death claims raise their own tax questions. Families should ask a tax adviser how the federal exclusion applies to their recovery, especially when several heirs share it. Punitive portions and interest still follow their own rules.
State Questions and Injury Settlement Taxes
State tax rules may differ from federal rules on some points. So ask a tax professional about California treatment of your specific settlement as well. Bring the agreement and the settlement statement to that meeting, since the adviser will want to see the actual language.
Common Misunderstandings
Some people assume every settlement is tax free. Others assume every settlement is taxable. Neither view is accurate.
The answer depends on the type of harm, the parts of the payment and your own past tax returns. Also review any tax form you receive from a payer with an adviser, rather than assuming what it means. A short meeting before filing your return can prevent errors that take far longer to fix later.
Records to Keep
- The signed settlement agreement
- Any allocation among damage categories
- The settlement statement showing fees, costs and liens
- Prior year returns if you deducted medical expenses
Keep these with your tax records. If questions come up years later, the documents show what the payment covered. For the full picture of deductions from a settlement, see medical bills pending settlement.
This article is general information, not legal advice. Laws change and every situation is different.