Whether you have already received compensation for injuries sustained in an accident or you have filed a claim but do not yet know how much you will receive, you may worry about the impact, or potential impact, of that claim on your taxes. You do not want to spend all of that money as it comes in, only to discover after the fact that you face substantial taxes on that settlement—especially if you have little income coming in during this difficult time.
Always consult a tax professional or talk to your attorney about what preparations you should make for taxes after any kind of change in income, including an insurance settlement. However, some general guidelines may help you assess how you need to manage those funds.
What the IRS Has to Say About Taxing Personal Injury Settlements
The IRS notes,
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.
That means that, in general, you should not have to worry about taxes on a settlement received because of a physical injury or illness caused by another party. Proceeds for emotional distress or mental anguish that result from your injury also do not qualify for taxation at the federal level.
You will want to check to see if your state taxes settlements or judgments differently than the federal government.
Your personal injury lawyer or an accountant can discuss the tax implications of any compensation you recover.
You should never let fear of taxation prevent you from seeking damages when someone injures you. Call a personal injury lawyer today to find out why.
Exceptions to Non-Taxable Settlements
While you do not have to worry about the IRS taxing your settlement amount for a specific injury, you may want to consider some circumstances under which you will need to report your settlement income or award to the IRS, and under which you may expect to pay some taxes on that amount.
If You Deducted Medical Expenses Related to Your Injuries on Prior Years’ Taxes.
It can take a long time to resolve your personal injury claim. In the meantime, you may have considerable expenses, especially if you suffered an injury like a spinal cord injury, which could lead to immense medical expenses. Your accountant or tax preparer may have recommended claiming those expenses as deductions on your taxes to reduce your tax burden the previous year, especially if you had relatively low income or otherwise struggled to come up with the funds needed to pay your taxes that year.
If you claimed those medical expenses in the past, however, you may need to include the settlement amount for the portion of medical expenses that you deducted in previous years, at least as far as those deductions offered some benefit to your tax rates. If you claimed those medical expenses in a past year, consult a tax preparation professional to learn more about how you should include your current expenses and what steps you should take to protect yourself and decrease your tax burden as much as possible.
You Included Proceeds for Emotional Distress or Mental Anguish that Did Not Start with a Physical Injury or Illness.
Sometimes, you may receive a settlement for mental anguish or emotional distress that has nothing to do with a physical injury. Although these claims do not occur very often, you may need to include these funds as part of your income from the calendar year. However, you could deduct any medical expenses associated with treating those mental and emotional ailments. Consult a tax preparation professional for more information about how to accurately report that income.
You Receive Punitive Damages as Part of Your Settlement.
Unlike compensation for your medical bills, lost wages, and pain and suffering related to serious injuries, punitive damages, or exemplary damages, punish the party that caused your accident. They may include substantial compensation, depending on the liable party’s ability to pay and the extent of the damages, including the danger caused by the liable party. An example in a car accident lawsuit where punitive damages may be awarded is if the defendant was driving under the influence of alcohol or drugs, thus their actions intentionally caused harm to the victim. Punitive damages fall into the taxable income category, which means you will need to report them on your taxes for the year in which you received them.
Taxation on Employment-Related Lawsuits
Some settlements for employment-related lawsuits (including discrimination lawsuits) may include compensation for lost wages, including severance, back pay, or front pay. You should assume that employment-related lawsuits include taxable wages, which means you should expect to pay normal taxes on that amount for the year in which it was awarded.
If your settlement includes any lost wages, you should expect to pay normal taxes, including Medicare and Social Security, on your award. Consult a tax preparation professional to learn more about what taxes you should expect on those amounts, which you may need to base on your current income and not on the income for the year the wages came from.
How to Calculate the Taxes You Owe
The taxes you owe from a settlement will depend on several key factors, from the type of damages you received to how you chose to manage your taxes in the past. Your other income for the year may also impact the taxes you will owe on a settlement for employment-related funds. If you usually work with a tax preparation specialist or accountant to manage your taxes, you may want to consult that individual to learn more about your tax burden and how your settlement will affect it.
An accountant may also provide vital information about how to best manage your funds to ensure that you pay your tax debt and manage your settlement effectively, increasing your ability to pay your bills despite your limitations.
Did you suffer serious injuries in an accident due to the negligence of another party? Should you expect compensation in the form of a settlement? An attorney can help you seek the compensation you deserve. Contact a personal injury attorney to learn more about your right to compensation and discuss how much you should pursue, which can help you prepare for the potential tax burden associated with a settlement.