Are Personal Injury Settlements Taxable?

Sometimes, when personal injury plaintiffs are awarded settlements, they question whether they’ll be able to retain the full amount of compensation offered. In situations such as lottery winnings or gambling proceeds, more than 25% of earnings may be withheld for tax purposes. So, are personal injury settlements taxable?

Below, Dellacona Law Firm explains how taxable and non-taxable damages work in personal injury settlements. For clearer information regarding your case, please speak with a tax advisor or a personal injury attorney in Macon, GA.

Taxation Requirements on Different Types of Personal Injury Settlements

Personal injury compensation falls into its own class of taxation requirements because of the damages caused by bodily harm or physical injury, which may not always arise in other types of civil lawsuits. Depending on the nature of the damages, certain portions of personal injury settlements may not be subject to federal income tax. In general, taxation requirements break down into two categories:

• Damages caused by physical injuries are typically not taxable.
• Damages that are not directly related to physical injuries may be subject to income tax.

To better explain how this rule applies and to fully answer “Are personal injury settlements taxable?” let’s look at the different types of compensation below.

Damages Related to Injuries or Illnesses

Damages directly related to an injury might include medical expenses, hospital stays, rehabilitation costs, ambulance transfers, medical equipment, prescription medications, and more. Under IRS Section 104(a)(2), compensation related to physical injuries is generally non-taxable.

A few exceptions may arise here. For example, if you deducted your medical expenses on Form 1040, a portion of your settlement may still be taxable.

Pain and Suffering Compensation

Pain and suffering can be taxable or exempt, depending on your case’s circumstances. If you suffered emotional distress due to your physical injuries, and this is what you claimed in your personal injury case, then your pain and suffering compensation may be exempt. For example, if you have a permanent disfigurement from the accident that has affected your mental health, your pain and suffering claim could be directly tied to your physical injury.

When mental anguish cannot be tied to bodily harm or injury, this portion of your settlement is typically taxable.

Lost Wages

Are personal injury settlements taxable? The answer becomes more complex when we look at benefits for unpaid wages.

If you cannot work for a period of time due to your injuries or condition, you may claim lost wages compensation. This type of damage generally follows similar standards as pain and suffering, where taxation depends on physical injury status. The IRS generally excludes lost wages related to physical injuries from gross income reporting.

In Georgia, you may still be required to report lost wages compensation on your tax return to pay state-level income taxes on your wages. Essentially, your compensation may be subject to state tax despite being exempt from federal income tax. Because of this complexity, it may be helpful to consult a tax advisor or personal injury attorney.

Property Damage Compensation

Property damage falls into a unique category that the IRS considers to be “compensatory.” Whether you have to pay taxes on compensatory damages often depends on how you’ve calculated your losses and the settlement you’re awarded:

• If your compensation equals the adjusted basis of your property’s value, it may be exempt from taxation.
• If the compensation is lower than the property’s adjusted basis, you may be able to deduct a loss.
• If your compensation exceeds the property’s adjusted basis, you may have to pay taxes on any gains.

The property’s adjusted basis is usually calculated by considering what you paid for it, any changes you made, and its depreciation. Calculating this figure correctly early on in your case may help clarify your tax responsibilities and support your claim for compensation.

Punitive Damages

By now, you’ve maybe discovered that the answer to “Are personal injury settlements taxable?” contains a lot of gray areas. While this is often true, the taxation rule for punitive damages is relatively straightforward.

Punitive damages are designed to punish the defendant when egregious misconduct or malicious intent caused harm to the plaintiff. This acts as a supplemental award for the plaintiff while simultaneously penalizing the defendant for their gross misconduct with the intention of deterring them from acting in a similar way again.

Punitive damages do not relate to one specific loss, so they are generally always taxable. Even if the case involves significant bodily harm or personal injury, the IRS considers punitive damages to be a form of income, which is subject to taxation.

Interest Gained on Settlement Awards

The above statements do not apply to any interest gained on settlement awards. For example, if you’re awarded a $50,000 settlement to cover medical expenses from an injury and you place these funds in a high-yield savings account that earns $1,800 in the first year, you need to report these earnings. While the original settlement may be exempt from reporting, any financial gains from savings accounts or similar investments will be considered income and treated as such.

Documenting Your Case Carefully To Avoid Tax Complications

Answering, “Are personal injury settlements taxable?” can be complex, especially if the case involves numerous types of economic and non-economic damages. To avoid potential tax complications, you should document all losses carefully up front, as this can streamline reporting requirements later on.

Consider keeping organized documentation of all medical expenses, property repairs, lost wages, and injury diagnostics. Your attorney may use these documents as evidence in your case, and you may need to reference such in the future for tax purposes.

Do You Need Help Pursuing Compensation?

So, are personal injury settlements taxable? While personal injury compensation is often exempt, certain portions of your settlement may still be subject to income tax. Whether you have to pay taxes on your damages often depends on how or if they relate to a physical injury.

If you need help pursuing a personal injury claim, call Dellacona Law Firm today at (478) 389-0548 to discuss your case details.