With Christmas less than a month away, you’ve been told your personal injury case has just been settled. Initially, you’re ecstatic at the prospect of a bountiful holiday, but then your practical side kicks in. Will you have to pay income tax on your recovery?
If you were injured in an accident, you have the legal right to recover financial damages for your related medical expenses, lost wages, pain and suffering, emotional distress, and mental anguish.
Medical Expenses
All personal injury settlements include reimbursement for injury-related medical expenses. Strictly speaking, this money is not taxable, and only becomes taxable if you deduct those same medical expenses on your tax return.
According to the IRS, if you receive a settlement for personal injury or physical illness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount of your settlement is nontaxable. In other words, don’t include it as income on your tax return.
But, if you did deduct a portion of the settlement for medical expenses in a prior tax year, that portion must be included as income. If part of the proceeds is for medical expenses you paid in more than one year, you are required to allocate, on a pro rata basis, the part of the proceeds to each of the years the medical expenses were paid.
Property Damage
Compensation for property damage, which may include a totaled car or a wrecked bicycle, is a clear example of a nontaxable settlement, since the point is to restore you to the position that you were in before your accident, meaning from a tax perspective, you are not earning income or profits by collecting these compensatory awards.
Emotional Distress or Mental Anguish
Any award you may have received for emotional distress or mental anguish from a personal injury is treated the same as proceeds received for personal injuries or physical illnesses. However, if the award you received for emotional distress or mental anguish did not arise from a personal injury or physical illness, it must be included as income, although attributable medical expenses can reduce the amount you must claim.
Lost Wages
If you receive a settlement in an employer-related lawsuit, the portion of the proceeds for lost wages (front pay, back pay, severance pay) is considered taxable income and should be reported on you income tax return.
Punitive Damages
Punitive damages are taxable and should be reported as “other income,” even if they were awarded in a personal injury settlement. A settlement agreement that includes specific language that no part of the award is for punitive damages can help a plaintiff avoid taxes on these types of damages.
Generally, money awarded in a personal injury settlement is tax-free, because it is considered compensation for a loss, not earned income. An experienced Colorado personal injury attorney will not only be able to get you maximum compensation for your injuries, but also advise you about the taxability of your recovery.
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