The Answer: It Depends
Your Colorado personal injury case just settled for more than you imagined, even after paying your attorney, your medical bills, and the other costs associated with your case. But before you start spending your newfound windfall, you’ll need to determine whether or not your settlement will be considered taxable income.
Neither the federal government nor Colorado can typically require you to pay taxes on the settlement proceeds of most personal injury claims, since this money is intended to compensate an injury victim for medical bills, lost wages, pain and suffering, and attorney fees, as long as the award arose from a physical injury. However, if no actual physical injury occurred, the award will generally be considered taxable.
What constitutes medical expenses for physical injuries is quite broad; payments to a psychiatrist, chiropractor, physical therapist, and counselor all qualify, as do bills from a massage therapist and acupuncturist.
Determining Whether Your Personal Injury Award is Taxable
According to the Internal Revenue Service (IRS), if you receive a personal injury settlement for a personal physical injury or illness and did not previously take an itemized deduction for medical expenses related to the incident, the full amount is not taxable and you do not have to include the settlement proceeds as part of your income. Likewise, any settlements received for emotional or mental distress arising from a physical injury or sickness will generally be treated in the same way.
However, there are several notable exceptions:
- If you receive a personal injury settlement for physical injuries or illness and you deducted any portion for medical expenses in the previous year to obtain a tax benefit, you must include that portion of the settlement as income. If part of the proceeds was for medical expenses paid in more than one year, you must allocate the part of the proceeds paid for medical expenses to each of the years they were paid as “Other Income”, on a pro-rata basis.
- If the award you receive for emotional distress or mental anguish did not arise from a personal injury or illness, it must be included in your income, although it may be reduced by the amount paid for medical expenses not already deducted, or the previously deducted medical expenses for mental anguish or emotional distress that did not provide you with a tax break.
- Any award for lost wages (severance pay, back pay, or front pay in an employment-related lawsuit is considered taxable wages and also subject to the social security wage base as well as social security and Medicare for the year it was paid. These proceeds are also subject to employment tax withholding and need to be reported as “Wages, salaries, tips, etc.” on line 7 of Form 1040.
- Punitive damages and pre- or post-judgment interest is generally considered taxable and should be reported, even if it was received as part of a personal injury settlement for a physical injury or sickness.
Interest on a settlement is generally taxable as interest income and should be reported to the IRS. Some personal injury plaintiffs might even need to make estimated tax payments if they anticipate their tax bill will be $1,000 or more, after subtracting tax credits and withholdings.