Are Personal Injury Settlements Subject To Federal Income Tax?

Personal injury lawsuits can go on for months or even years, regardless of whether you hire a personal injury lawyer or choose to handle the case on your own. If you are fortunate enough to see a successful resolution of your claim and you receive an insurance settlement for your injuries of other damages, it is important to understand the tax implications associated with your settlement.  

It is true that certain plaintiffs who receive money from a lawsuit judgment or out-of-court settlement from an insurance company may be subject to paying taxes on that money, depending on the nature of the claim.

IRS Does Not Tax Compensation For Personal Injury 

Fortunately for personal injury victims, however, the IRS does not tax compensation that comes as a result of a personal injury claim. If the person's settlement or award comes as a result of "observable bodily harm" - i.e. the person suffered visible bodily injury that is the primary purpose of the settlement or award - then that money will not be subject to taxation. 

It makes no difference if the compensation is in a lump sum or spread out through multiple installments. If you receive compensation for medical expenses, that money is also considered tax-free. However, if the victim claims a medical expense deduction for medical costs that are later reimbursed in a personal injury award, then the deducted amount must be reported as income on his or her tax return.

Compensation for lost wages, interestingly enough, is also considered non-taxable, despite the fact that those wages would have been subject to income tax if they had been earned through the course of employment. But if any of the compensation is considered interest for the delay between the victim’s injuries and the time that they receive compensation, then that portion is considered taxable.

Additional Forms Of Compensation Can Be Taxed

Compensation for legal injuries – i.e. harassment, discrimination, etc. – is subject to tax, as is compensation for emotional distress that did not result from personal injury or illness. That also goes for punitive damages – even if they are considered compensation for a person’s physical injury or sickness. This is a bit of a moot point though, since punitive damages are not allowed in Washington state.

If you incur legal expenses for attorney fees and other costs, you are not allowed to deduct those expenses on your tax return. It’s a fair rule, considering that the compensation you receive for a personal injury award is generally non-taxable.

This is important information for accident victims because many people assume that once they receive their settlement or award that the personal injury case is done and over with. Gaining a solid understanding of how the tax laws affect your personal injury compensation can help you avoid financial headaches in the future. For more information about tax rules related to damages awards, visit the IRS website and check out IRS Publication 525 – Taxable and Nontaxable Income.