Do You Pay Taxes on Personal Injury Settlements?
Receiving a settlement brings relief, but tax questions quickly follow. Understanding what's taxable ensures you keep as much of your compensation as possible.
The General Rule: Physical Injury = Tax-Free
Under IRS guidelines, compensation for physical injuries or physical sickness is generally not taxable. This includes:
- Medical expense reimbursement
- Compensation for pain and suffering
- Lost wages due to physical injury
- Emotional distress from physical injury
What IS Taxable in Settlements
Always Taxable
- Punitive damages: 100% taxable as ordinary income
- Interest earned: On any settlement portion
- Previously deducted medical expenses: If you claimed them as tax deductions
Potentially Taxable
- Emotional distress alone: Without physical injury connection
- Lost wages portion: In non-physical injury cases
- Business-related claims: Contract or economic disputes
Examples of Tax Treatment
Tax-Free Scenario
Car accident settlement for broken leg:
- $50,000 medical bills → Not taxable
- $30,000 pain and suffering → Not taxable
- $20,000 lost wages → Not taxable (connected to physical injury)
Taxable Scenario
Employment discrimination settlement:
- $50,000 emotional distress → Taxable
- $20,000 back pay → Taxable as wages
Settlement Allocation Matters
How your settlement is divided affects taxes:
- Work with your attorney to allocate properly
- Written allocation in settlement agreement helps
- IRS may challenge unreasonable allocations
Steps to Minimize Taxes
- Keep detailed records of all expenses
- Don't deduct medical expenses you expect to be reimbursed
- Discuss allocation with your attorney before settling
- Consider structured settlements for large awards
- Consult a tax professional for settlements over $100,000