Is Your Personal Injury Settlement Taxable?

Will the IRS view financial compensation for your injuries as taxable income? The short answer is: It depends. Read on to discover a comprehensive explanation of how your personal injury settlement may be taxed—or not taxed.

If you filed a personal injury claim believing your case would eventually go to court and be resolved by means of a trial, you may be in for a surprise. Though estimates vary, it is considered to be common knowledge that most claims settle without ever going so far as a lawsuit. You have every reason to be satisfied, though, if your lawyer manages to reach a settlement with the at-fault party. 

There are many reasons why you can see a settlement as a success. First, while the results of a trial can be unpredictable, a settlement allows both sides to hammer out an agreement tailored to the needs and demands of both parties. What’s more, a settlement means you will be awarded financial compensation for your injuries in the amount that your lawyer thought was fair and satisfactory. And finally, you will be able to access these funds much sooner than if a trial were underway.

Once you have accepted and signed the settlement offer, you may expect to receive your compensation as soon as within a few weeks—provided there are no unexpected delays. You must also remember that under the contingency fee arrangement, part of your compensation will be deducted as payment for your attorney. 

At this point, however, you may be wondering whether you are legally obliged to pay any taxes on your personal injury settlement. In this article, we provide a comprehensive answer to this important question.

Compensation for Your Personal Injury

As the saying goes, ‘nothing is certain except for death and taxes.’ Yet, the compensation you receive for your physical injuries will not be taxed, neither under the federal law nor the law of the State of New Mexico. 

Therefore, the Internal Revenue Service (IRS) will make no claim to the proceeds from your settlement, as these are not generally considered to be taxable income. The insurance company responsible for the payout of your compensation will inform the IRS by submitting an appropriate claim.

Compensation for physical injuries is, in fact, designed to reimburse you for various kinds of expenses you have incurred as a result of these injuries. These may include:

• Medical bills
• Physical pain and suffering
• Emotional distress directly resulting from the injuries
• Loss of consortium

The amount you receive as compensation for the losses mentioned above will typically not be subject to taxation.

When Your Compensation May Be Taxable

As explained above, you will not be taxed on your settlement as long as the compensation you receive is for your physical injuries. Any compensation you receive for the psychological and emotional impact of the accident, however, could be taxable.

You are likely to be taxed for compensation regarding the emotional repercussions when they are not directly related to your physical injuries. Such repercussions may include:

• Insomnia,
• Headaches,
• Stress,
• Nightmares,
• PTSD; and 
• Similar symptoms.

In addition, if you have waited for the resolution of your case for more than a year and have claimed injury-related medical expenses for a tax deduction, the part of your compensation covering these expenses may now be taxable. 

Moreover, if your claim does end up in court, depending on the circumstances of your case, you may also be awarded a substantial amount as punitive damages. In some cases, there may also be post-judgment interest that would further increase your compensation payout. In such a case, it is important to remember that both punitive damages and post-judgment interest are subject to taxes. 

What if you missed work due to your physical injuries and therefore are compensated for lost wages? Just as you would be taxed for earned wages, you are to pay taxes for reimbursement of lost wages.

An experienced attorney is usually keenly aware of the intricate relationship between personal injury and taxation laws. In some cases, it may be possible to minimize the taxes you must pay on your settlement by explicitly stating the portion of the amount related to your physical injury. However, if you have further concerns about taxes on your settlement, it may be best to discuss this in detail with your attorney.