Are Personal Injury Settlements Taxable?
Understanding the tax implications of your personal injury settlement is crucial for financial planning. The good news is that most personal injury compensation is tax-free, but there are important exceptions.
What's NOT Taxable (Tax-Free)
Physical Injury Compensation
- Medical expenses: Reimbursement for treatment costs
- Pain and suffering: Related to physical injuries
- Lost wages: When connected to physical injury
- Property damage: Vehicle repair or replacement
- Wrongful death: Most proceeds to beneficiaries
What IS Taxable
Non-Physical Claims
- Emotional distress only: Without physical injury
- Defamation: Damage to reputation
- Discrimination: Employment-related claims
- Contract disputes: Business-related injuries
Specific Settlement Components
- Punitive damages: Always taxable as income
- Interest on awards: Taxable as ordinary income
- Previously deducted medical expenses: May be taxable
Important Tax Rules to Know
The "Origin of the Claim" Test
The IRS looks at what the settlement compensates for, not what it's called:
- If it replaces physical injury damages → Tax-free
- If it replaces lost income unrelated to physical injury → Taxable
Medical Expense Deduction Rule
If you deducted medical expenses in a prior year, the reimbursement portion may be taxable. This prevents a "double benefit."
Structured Settlements & Taxes
- Periodic payments remain tax-free if the original settlement was tax-free
- Interest earned on structured settlement funds may be taxable
- Consider long-term tax planning with large settlements
Protecting Your Settlement
- Settlement allocation: Work with your lawyer to properly allocate funds
- Documentation: Keep records of what each portion compensates
- Consult a tax professional: For settlements over $100,000