When you receive compensation, whether from a settlement or a court award, it’s natural to wonder how much of that money you get to keep. Obviously, a portion of your compensation goes to personal injury attorneys for their hard work.
People often wonder whether the compensation they receive is taxable. To answer this question, we need to look at the different types of compensation and how they are taxed.
Tax Implications on Personal Injury Compensation
When you receive a personal injury settlement, understanding the tax implications is crucial to ensure you keep as much of your compensation as possible and comply with IRS regulations. Generally speaking, Uncle Sam does get a cut from certain types of compensation. However, different types of compensation, such as physical injuries, emotional distress, lost wages, and punitive damages, have varying tax treatments. For more detailed information, you can refer to the IRS guidelines on the taxability of settlements and judgments.
Taxable Personal Injury Compensation
Certain types of personal injury compensation are considered taxable by the IRS and must be reported as income on your tax return. These include:
- Emotional Distress Not Linked to Physical Injury: If you receive compensation for emotional distress or mental anguish that is not directly related to a physical injury or sickness, this amount is taxable. For instance, if you receive a settlement for stress caused by a workplace incident without any physical or bodily harm, you must pay taxes on that amount.
- Lost Wages: Compensation for lost wages is treated as ordinary income. Essentially, the IRS views this type of compensation as a replacement for the income you would have earned if you hadn’t been injured.
- Punitive Damages: Punitive damages, which are intended to punish the wrongdoer and deter future misconduct, are always taxable. The IRS treats these as a form of income, so you must include them when filing your tax return.
- Interest on Settlements: Any interest that accrues on a settlement amount is taxable. Even if the principal amount is not taxable, the interest earned is considered income and must be reported. This applies to interest on delayed compensation or on the amount awarded by the court.
Non-taxable Personal Injury Compensation
On the other hand, certain types of personal injury compensation are non-taxable and do not need to be reported as income. These include:
- Compensation for Physical Injuries or Sickness: The IRS generally does not tax compensation received for physical injuries or sickness. The reasoning is that this type of compensation is meant to make you whole, not to provide additional income.
- Medical Expenses Previously Not Deducted: If you receive compensation for medical expenses that you did not previously deduct on your tax returns, this amount is non-taxable. This ensures that you are not taxed on reimbursements for costs that you paid out of pocket without receiving a tax benefit.
- Related Emotional Distress: If emotional distress is directly related to a physical injury or sickness, the compensation for this distress is not taxable. For example, if you suffer emotional distress as a result of a car accident that also caused physical injuries, the compensation for that distress is non-taxable.
