If you’ve been injured in an accident that wasn’t your fault, you may be entitled to compensation. A settlement or court judgment can be sizable — even life-changing — to cover your past and future medical expenses, lost wages, and property damage, and compensate you for your pain and suffering, mental anguish, and your injury’s long-term impact on your quality of life.
But do you have to pay taxes on your settlement? This is a common concern for many of our clients, and it’s a vital question to consider if you’re considering pursuing a claim.
After all, navigating the legal process of pursuing compensation while you’re trying to focus on your recovery can be stressful. Insurance adjusters might hound you for updates on your injuries or a statement about what happened. Your employer might be pressuring you to return to work — and you might be tempted if you have a family to provide for. You’re entirely justified in wondering, “Is it all worth it?”
In this blog post, we break down what goes into calculating a settlement and the various factors that affect how much you receive, how personal injury settlement tax works, whether settlements and judgments obtained via a lawsuit are taxed differently, and what steps to take to maximize your compensation while complying with Texas tax laws.
Understanding Personal Injury Settlements
When you’re injured due to someone else’s negligence — whether in a car accident, a slip and fall, or any other incident — you may be entitled to compensation for your injuries and related expenses. This compensation often comes as a settlement, where the at-fault party (or their insurance company) agrees to pay you a sum to resolve your claim. Accepting a settlement prevents you from pursuing legal action later.
A typical personal injury settlement might include compensation for:
- Medical expenses
- Lost wages
- Pain and suffering
- Property damage
- Future medical costs
- Loss of earning capacity
If negotiations fail, you might choose to file a lawsuit, which begins the personal injury court procedure. During this process, both parties will engage in discovery (gathering evidence) and proceed toward trial. During a trial, a jury will hear evidence from the plaintiff (the injured party) and the defendant (the at-fault party defending the claim), and determine if the defendant is liable. If the jury finds fault, they can award compensation for the aforementioned damages. They can also award punitive damages if they find a defendant’s conduct to be especially egregious.
However, settlement negotiations continue throughout the pre-trial process, an an agreement may be reached before you get a court date.
Do You Have to Pay Taxes on Your Settlement?
Generally, the bulk of your personal injury settlement will not be taxable. The Internal Revenue Service (IRS) typically does not consider personal injury settlements as income, which means you don’t have to report them on your tax return.
This rule applies to lump-sum settlements (paid in one go) and structured settlements (payments over time). The reason for a lack of personal injury settlement tax lies in the purpose of compensation — it is meant to make you “whole” again after your injury and compensating you for your losses, not providing you with additional income.
However, as with many aspects of tax law, there are some exceptions and nuances to be aware of.
Understanding the Exceptions: When Parts of Your Settlement May Be Taxable
A personal injury settlement is, for the most part, not taxed, but there are specific scenarios when your compensation might be subject to taxation.
Interest on Your Settlement
If your case takes a long time to resolve and you receive interest on your settlement amount, that interest is taxable. For example, if you’re awarded $100,000 in damages plus $5,000 in interest, you would need to report that $5,000 as income on your tax return.
Punitive Damages
If your settlement includes punitive damages — which are intended to punish the defendant for particularly egregious behavior rather than compensate you for your losses — these are generally taxable. It’s worth noting that punitive damages are relatively rare in personal injury cases in Texas, but if they are part of your settlement, you’ll need to report them as income.
Emotional Distress or Mental Anguish
Compensation for emotional distress or mental anguish is not taxable if it’s related to a physical injury or physical sickness. However, if you receive compensation for emotional distress that’s not tied to a physical injury, it may be taxable.
Lost Wages
If part of your settlement is specifically allocated to cover lost wages or lost business profits, this portion may be taxable. The reasoning is that if you had earned this money through work, it would have been taxable income, so the settlement portion replacing this income is also taxable.
Medical Expense Reimbursement
While the portion of your settlement that covers medical expenses is generally not taxable, there’s an important caveat. If you deducted medical expenses related to your injury on a prior year’s tax return and then received a settlement that included compensation for these expenses, you may need to report this as income. This is known as the “tax benefit rule.”
How to Minimize the Tax Impact of Your Settlement
Given these potential tax implications, what can you do to minimize the impact on your taxes? Here are a few strategies:
1. Clearly Allocate Settlement Funds
When negotiating your settlement, work with your attorney to clearly allocate the funds. Specify how much is for medical expenses, pain and suffering, lost wages, etc. This can help prevent the IRS from arguing that a larger portion of your settlement is taxable.
2. Consider a Structured Settlement
For larger settlements, consider a structured settlement where you receive payments over time instead of a lump sum. This can help manage your tax liability and provide long-term financial security.
3. Be Careful with Medical Expense Deductions
If you’re anticipating a settlement, be cautious about deducting medical expenses related to your injury. While you’re entitled to these deductions, remember that you may need to report them as income later if your settlement covers these costs.
4. Keep Detailed Records
Maintain thorough records of all expenses related to your injury, including medical bills, travel costs for treatment, and any other out-of-pocket expenses. This documentation can help support the tax-free status of your settlement.
5. Consult with a Tax Professional
Tax law is complex, and the rules surrounding personal injury settlements can be particularly nuanced. It’s always a good idea to consult with a tax professional who can provide advice tailored to your specific situation.
The Importance of Proper Settlement Negotiation
The way your settlement is structured and worded can have significant implications for your tax liability. This is one of the many reasons why it’s crucial to have an experienced personal injury attorney on your side during settlement negotiations.
At Patino Law Firm, we understand the complexities of personal injury settlements and their potential tax implications. We work diligently to structure settlements in a way that maximizes our clients’ compensation while minimizing their potential tax burden.
For example, we might negotiate to allocate a larger portion of the settlement to non-taxable categories like pain and suffering or medical expenses, rather than lost wages. Or, if punitive damages are on the table, we might push for a larger compensatory award instead, as this would likely be non-taxable.
What to Do If You’ve Already Received a Settlement
If you’ve already received a personal injury settlement and are unsure about its tax implications, don’t panic. Here are some steps you can take:
- Gather all documentation related to your settlement, including the settlement agreement and any correspondence about how the funds were allocated.
- Consult with a tax professional who has experience with personal injury settlements. They can help you understand your obligations and prepare your tax return correctly.
- If you’re concerned that you may have incorrectly reported (or failed to report) a past settlement on your taxes, consider speaking with a tax attorney about your options. In some cases, you may be able to file an amended return.
- Moving forward, keep detailed records of how you spend your settlement funds, especially if any portion is intended for future medical expenses.
Dealing with the aftermath of an injury is challenging enough without having to worry about potential tax implications. While it’s reassuring to know that most personal injury settlements are not taxable, it’s important to be aware of the exceptions and to approach your settlement with a clear understanding of its potential impact on your taxes.
We’re committed to helping our clients navigate every aspect of their personal injury claims, including understanding the potential tax implications of their settlements. We work closely with our clients and, when necessary, with tax professionals to ensure that our clients’ rights are protected and their compensation is maximized.
If you’ve been injured due to someone else’s negligence and are considering pursuing a personal injury claim, don’t go it alone. Our experienced attorneys can guide you through the process, help you understand your rights, and work to secure the compensation you deserve – while also considering the long-term financial implications, including taxes.
Remember, every case is unique. For specific advice about your situation, it’s always best to consult with a qualified personal injury attorney and a tax professional.
Contact Patino Law Firm today for a free, no-obligation case review. Our personal injury attorney in San Antonio and McAllen can help you get the compensation you deserve and maximize your recovery. Se habla Español, and you won’t pay fees until we win.
