Is a Personal Injury Settlement Taxed?

Approximately 6 percent of adult Americans experience an activity-limiting injury every three months, according to the Centers for Disease Control and Prevention (CDC). Injuries can happen because of carelessness, such as distracted driving or a slippery floor at a restaurant or store. In fact, accidental injuries are also the fourth-leading cause of death.

Many people become injured in their workplace, resulting in a disability. According to the National Safety Council, workplace injuries occur as often as every seven seconds. The Social Security Administration (SSA) reports that 45 percent of men and 26 percent of women receiving disability benefits became impaired because of workplace accidents, injuries, or illnesses.

In addition to causing death and disability, injuries claim a significant economic toll. The CDC estimates that in 2019, the economic cost of injuries was $4.21 trillion. This comprised $327 billion in medical care and $69 billion in loss of work.

Personal Injury Lawsuits

If someone’s negligent actions cause an injury, the injured person can make a personal injury claim. This is where the help of personal injury lawyers comes in. The purpose of these types of claims is to recover compensation for the injury.

Most claims primarily involve compensation for the financial and emotional cost of the injury. However, in cases of severe negligence, injured people can also receive additional money intended to punish the party responsible.

Personal Injury Settlements

When injured people bring claims against those at fault, they often reach a settlement agreement and receive compensation. For example, in the case of car accidents caused by negligence, automobile insurance companies would typically pay the settlement payments. (These payments might go to the injured individual as a lump sum or in installments.)

The Law Dictionary reports that approximately 95 percent of personal injury cases settle before trial. For those cases that result in a trial, more than 90 percent end with an injured person or surviving family winning the case and receiving a money judgment.

Are Lawsuit Settlements Taxable?

Whether a personal injury settlement is entirely or partially subject to federal income tax depends on the type of compensation the injured party receives. Personal injury damages fall into different categories, such as compensatory damages. These types of damages may compensate for things like lost wages or the cost of litigation. Other categories include punitive damages and damages for emotional distress. Some damages are not subject to federal income tax.

The purpose of compensatory damages is to make the injured person “whole.” This type of compensation provides for money lost.

For example, someone injured by a distracted driver could receive compensatory damages that make up for the financial losses from the accident. Compensatory damages could cover the cost of medical bills, follow-up appointments, and physical therapy. It also can address income diminished by loss of wages as well as the impact of pain and suffering.

Because compensatory damages make up for financial losses directly resulting from the incident, they are generally not subject to income tax. To be tax-exempt, however, the compensation must address a physical injury.

The Internal Revenue Service (IRS) typically considers compensation for emotional distress, mental harm, and mental illness as taxable income received. This is because the financial toll of mental anguish can be more challenging to measure. For example, someone who developed post-traumatic stress disorder (PTSD) following an accident might have to pay taxes on compensation for their PTSD.

Although not common, victims of gross negligence may receive punitive damages in addition to compensatory damages.

Punitive damages do not seek to make the person whole; instead, they punish the wrongdoer. Punitive damages do not provide compensation for direct, measurable loss. Therefore, they do count as income and are subject to federal income tax.

State income tax rules vary. Some states, such as Florida, do not have an income tax. When states impose an income tax, taxation of settlements often reflects the federal rules.

How to Avoid Paying Taxes on Settlement Money

Advocating for their client, an attorney may negotiate a settlement that avoids federal income tax. Compensatory damages for physical injuries are generally not taxable. So, the attorney may emphasize the need for this type of compensation during negotiations. Some agreements explicitly state that the damages are not taxable.

Even before you settle a personal injury lawsuit, consider consulting with an experienced special needs planning attorney. Or you may want to direct your personal injury attorney to connect with one. Special needs planning attorneys can offer guidance on settlement planning.

If you have suffered an injury that has resulted in disability, you may qualify for public assistance. Special needs planners can help identify the benefits programs for which you are eligible. They will have expertise on how a settlement might affect certain government benefits, such as Social Security Disability Insurance.

They also can assist you in establishing a Medicare Set-Aside trust when necessary. (These types of arrangements hold settlement money for future medical bills.)

Find a qualified special needs planning attorney near you today.

You may also benefit from referring to the following articles:

• Before Settling a Personal Injury Claim, Consider a Special Needs Trust
• The Advantages and Drawbacks of Structured Settlements
• Five Questions to Ask Before Settling a Personal Injury Lawsuit
• Special Needs Planning Q&A: What Is Workers Compensation?
• Proper Planning for Your Child’s Personal Injury Settlement