Personal Injury Settlements and Tax Implications
If you suffered an injury caused by someone else’s negligence or misconduct, and you plan to file a lawsuit to recover compensation, there’s a good chance your claim will end in a settlement. Most personal injury claims and lawsuits end with a settlement, which is when both sides agree to a set amount of compensation to avoid going to trial.
But do you have to pay taxes on personal injury settlements? Is this something you should be concerned about?
The good news is that, in most cases, your personal injury settlement, or at least a majority of it, will be tax-exempt. This is because personal injury settlements aren’t considered a financial gain. Instead, they repay you for your financial losses.
However, some exceptions may still apply to your case, and understanding them can be crucial when planning your settlement. For this reason, you should speak to an experienced personal injury attorney before accepting any settlement offered by the negligent party’s insurance company. Call Ted A Greve & Associates PA today for a consultation about how we can help you with your case.
Taxable Components
The money you receive through a personal injury settlement falls into one of three categories:
- Economic Damages – This is the compensation you receive for your tangible losses, including medical expenses, lost wages, and property damage.
- Non-Economic Damages – This is the compensation you receive for your intangible losses, including pain, suffering, and emotional distress.
- Punitive Damages – This is additional money you receive that doesn’t compensate you for any loss but instead punishes the at-fault party for particularly reckless behavior.
In general, economic and non-economic damages are not taxable because they compensate you for your losses. But, according to the IRS, if you receive punitive damages through your personal injury lawsuit, that money is taxable.
The vast majority of personal injury lawsuits don’t involve punitive damages, so it’s unlikely that this is something you’ll need to consider.
Exception Cases and Their Tax Implications
Beyond punitive damages, there are a few other exceptions to the rule that compensatory damages don’t get taxed. These exceptions are emotional and psychological injuries, previously deducted expenses, and legal fees.
Emotional and Psychological Injuries
The rule that personal injury settlements aren’t taxable only applies if they’re for physical injuries. For example, if you slipped and fell, were in a car crash, or were hurt by a defective product, your lawsuit arises from a physical injury you sustained.
Even if you seek compensation for pain and suffering or emotional distress, as long as they arose from a physical injury, that compensation is tax-exempt.
However, if you sue for an injury that’s entirely emotional or psychological without a physical component, the compensation you receive through a settlement will be taxable. An example is if someone threatens you or puts your life in danger, causing psychological trauma, but doesn’t physically harm you.
Deducted Expenses
If your lawsuit lasts over a year, you may have listed your medical expenses and other financial losses connected to the injury as deductions on your taxes. In this case, you may have to pay taxes on the money you get in your settlement for those deducted expenses.
This situation arises from the fact that personal injury settlements compensate you for a loss instead of providing a gain. If you write off the expenses as a deduction one year and then don’t pay taxes on the settlement the following year, you effectively “double dip” and come out with a gain.
Legal Fees
If you have to pay taxes on part or all of your settlement or award, you cannot deduct your legal fees. For example, if you have to pay taxes on a $100,000 settlement and have $35,000 in legal fees, you still pay taxes on the total amount, not just the $65,000 you received after paying the fees.
While this won’t apply to most cases, it’s something to keep in mind when considering how personal injury taxes could impact your settlement.
How to Mitigate Tax Liabilities on Settlements
If your settlement is taxable, either in part or in full, there are some strategies you may be able to use to mitigate the impact. These include:
- Structured Settlement Annuity – Instead of receiving your settlement as a lump sum, you can receive it as a structured settlement. You can use your lump sum to purchase a structured settlement annuity to distribute payments yearly. While you don’t get all the money upfront, your total taxes will be lower.
- Compensation Allocations – There’s some wiggle room in how you can allocate compensation within your settlement. For example, if part of your settlement is taxable, you may be able to allocate a portion of that money to another part of your settlement that isn’t taxable.
- Qualified Settlement Funds – These 468B trusts can hold settlement money until a later date. By putting your compensation in a qualified settlement fund, you can defer the tax implications until a later year.
Taxable Benefits
One important point to remember is that interest is taxable, even on a tax-exempt personal injury settlement. If you put your settlement money in an account that accrues interest, you must still report it as interest income and pay taxes on it.
Depending on how close you are to the next tax bracket, the interest accrued by your settlement could significantly impact the total amount of taxes you pay in a year.
Conclusion: Seeking Professional Guidance for Optimal Outcomes
A personal injury attorney’s job isn’t only to win your legal case or secure a settlement. Their job is also to make sure that the settlement you receive is in your best interest financially, which involves considering the tax implications.
Before meeting with an attorney for the first time, you should prepare a set of questions to ask. These questions may include:
- How much the attorney thinks your case may be worth
- What the attorney’s fee structure looks like
- What the tax implications of a settlement in your case may be
If you suffered an injury caused by someone else’s negligence, contact Ted A Greve & Associates PA for a free consultation. Our experienced attorneys will review your case, explain your legal options, and go over the taxability of personal injury settlements with you.
Photo Credit Via: Unsplash
