Do you have to pay taxes on Personal Injury Settlement?

Do you have to pay taxes on Personal Injury Settlement?

Questions about taxes and personal injury settlements are very common. This is understandable. You have to think about how much money you’ll actually get if you accept a settlement, and that includes figuring out the tax situation. You may know someone who received a personal injury settlement, then unexpectedly received a large tax bill because of it. However, it’s important to know that this isn’t always the case.

So is your personal injury settlement taxable? The answer is not always straightforward, as the tax code is complex, and it’s best to consult a licensed CPA or your Virginia personal injury attorney about any tax questions. However, there are some general rules that apply in most situations of personal injury settlements. Here are some of the different types of awards you may receive in a personal injury settlement, and how they are usually affected by tax law:

Compensatory Damages

What are compensatory damages exactly? Compensatory damages are money awarded to a plaintiff in a personal injury case to compensate for damages, injury, or another loss that happened due to the negligence or unlawful conduct of another party. (This party may be one or more individuals, or an entity such as a business, community organization, or even a church or other religious institution.)  In order to receive compensatory damages, the plaintiff needs to demonstrate that the loss is real and that it was caused by the defendant.

So are compensatory damages taxable? In most cases, no. Usually settlements for losses involved with physical injuries or illnesses, like broken bones, head injuries, brain damage, traumatic brain injury (TBI), paralysis or spinal cord injuries, loss of vision or hearing, loss of limbs, etc., are tax-exempt.

You also shouldn’t have to pay taxes on portions of a settlement that are supposed to pay for things like medical care, repairs to your car or other property, legal fees, loss of quality of life, emotional distress, loss of consortium, or wrongful death. So, for example, if you are awarded an amount of money for loss of consortium and wrongful death after your spouse died in an accident caused by someone else’s negligence, you would not have to pay taxes on that award.

However, there are some situations where personal injury settlements are usually taxable:

Pain and Suffering Without Injury

Pain and suffering often accompanies a physical injury, such as a broken bone, and you can sue for both the physical injury and the costs you’ve incurred in treating it, and the emotional pain and suffering it caused you. You can also sue for pain and suffering in situations where you haven’t had a physical injury. For example, some people develop PTSD after suffering a traumatic experience, even if they were not physically injured when this happened. Unfortunately, the IRS makes an exception on the “nontaxable” status of settlements for pain and suffering without physical injury. So these types of awards are typically taxed.

Lost Wages

If you or a loved one do suffer a physical injury, in addition to physical pain and suffering, permanent disability, and medical expenses, you may also have to deal with the financial problem of lost wages. Frequently people who are seriously injured are out of work for days, weeks, or even months. For this reason, you can also sue for your lost wages. However, an award for lost wages is also usually taxable. Typically you will pay whatever you normally pay in income taxes—the idea being that you would have paid taxes on your income anyway if you’d continued to work. So if you know your usual income tax rate, you can easily figure out how much you will lose from this award.

Punitive Damages

What are punitive damages? These are meant not just to compensate the plaintiff, but to also provide a harsher punishment for the defendant in situations where the defendant is found to be wildly or grossly negligent in some way. Essentially, punitive damages are meant to be an extra punishment, on top of compensatory and lost wage damages, for recklessness, intentional misconduct, or complete disregard for the safety of others. 

For example, a chemical company that recklessly and repeatedly dumped toxic waste in a town’s water supply, leading to many of the town’s residents developing cancer or other illnesses, despite knowing the waste was toxic and could harm the water supply, might be given punitive damages in a personal injury lawsuit. The judge might do this to show the chemical company that while it saved money by disposing of its toxic waste in an unsafe way, it will now lose much more money in punitive damages. The hope is the chemical company executives will learn their lesson and just pay to dispose of the toxic waste properly next time.

If the judge awards you punitive damages in your case, you will need to pay taxes on them. This includes interest paid by the defendant. However, punitive damages are rarely awarded in personal injury cases, so it is unlikely you will need to worry about this.

Tax Deduction Expenses

In some cases, plaintiffs who have extensive medical bills will have taken these as deductions on their taxes, because in most cases you are allowed to deduct medicare expenses. If you then receive this money back in the form of compensation for your injuries, then you will need to pay the taxes you didn’t pay when taking this money as a deduction. Essentially, the IRS doesn’t permit anyone to get a tax deduction twice—if you already deducted the sum of your medical bills from your taxes last year, you’ll need to pay income tax when you receive that sum back as a settlement.

Lawsuits Involving Damages Without Injuries

Physical or emotional injuries are not the only situations where one can file a lawsuit and receive damages. You may receive damages in a lawsuit over wrongful termination, a breach of contract, or other business disputes, for example. In some situations, plaintiffs may point out that the stress of being fired may have caused a chronic condition to flare up or triggered a migraine. However, if your lawsuit is not about your physical ailment, than you will have to pay taxes on the award.

What About Health Insurance?

There is another loophole involving health insurance coverage purchased through the Affordable Care Act (ACA) health insurance marketplace. These health plans are based on income, and awards from lawsuits are sometimes considered income. If you do not go onto the marketplace and adjust your income accordingly, you may have a tax credit amount that’s too high based on your actual earnings. If that occurs, then you could get a larger tax bill at the end of the year. It’s best to update your income as soon as possible to prevent that from happening, even if it causes your premium price to go up.

If you have questions about a personal injury settlement or case, please contact a personal injury lawyer in Virginia who offers a free consultation, so you can learn more about the ways you can proceed. Your personal injury attorney will be able to make recommendations about how to minimize your tax burden after a personal injury settlement.