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After a year of back and forth negotiations, countless doctor's visits, and lots of pain and suffering, your lawyer got you a settlement award for your personal injury claim.
Congratulations! You now get to pocket that money and go on your merry way. But, wait just a second. The tax man would like to speak with you real quick. Part of that settlement you got might belong to him.
So, is your personal injury settlement award really taxable?
Yes and No
Whether or not a settlement award is taxable depends on what it compensates you for. For example, you were injured at work by a rolling office chair breaking your knee caps, and your settlement award was:
What do you have to pay taxes on?
Money you earn is taxable. So, a settlement award that compensates you for lost wages is also taxable.
Damages for physical injuries are not taxable. If the medical bills you incurred were for physical injuries, then the award meant to compensate you for medical bills are not taxable. However, if you've already deducted your medical bills on previous tax returns, then the settlement is taxable.
Pain and Suffering
Again, remember that damages for physical injuries are excluded from your income. As long as your pain and suffering arose from a physical injury, such as breaking said knee caps, then the settlement award is not taxable.
Interestingly, the IRS believes that emotional distress, such as depression or anxiety, are not physical injuries. So, any amount awarded to compensate for emotional distress is taxable. But, if the money was meant to reimburse for medical bills, such as psychiatric treatment for depression, then it is exempt from taxation.
Punitive damages are meant to punish the defendant for bad behavior, not to compensate you for an injury. As such, punitive damages are always taxable. No ifs, ands, or buts about it.
Some states add an interest award to the judgment for the time the case was pending. For example, your lawsuit was pending for a year. The court adds one year of interest onto the judgment. This amount is considered unearned income and is taxable.
You can also get interest on a judgment if the defendant delays payment. If a defendant waits two years before paying a judgment, you get two years of interest on top of the amount awarded. This amount is also taxable.
Going back to our scenario, assuming that there are no medical deduction exceptions, the $60,000 award for lost wages, medical bills, and pain and suffering is not taxable. The $45,000 award for punitive damages and interest is taxable.
If you received a personal injury settlement and are unsure of your tax liability, an experienced tax attorney may be able to help.