It is important for plaintiffs in personal injury cases to understand the exact amount that they will receive after a case is resolved. The funds that a plaintiff will actually take home and be able to use for their recovery will be lower than the actual settlement or verdict, because attorney fees and costs are generally taken out of the settlement or verdict amount.
Similarly, a common concern is whether or not taxes are taken out of the personal injury settlement funds that a plaintiff receives. Everyone knows the significant bite that taxes take out a paycheck. Does the same apply to a check received following an injury settlement? Fortunately, for the most part, personal injury settlements are tax-free, though there are exceptions that need to be understood.
Purpose of Personal Injury Settlements
The purpose of a personal injury settlement is to make you whole again, and taxing the settlement would detract from that purpose. In other words, a settlement is viewed as a re-couping of losses, not a windfall of extra income upon which you need to be taxed.
Tax Free Recovery
When you receive an award, it is generally broken up into components which indicate what portion of the overall award is being paid for each specific “loss”–lost income, medical expenses, pain and suffering, etc. This breakdown determines which portions of the award might be subject to tax.
Settlements received for a physical injury are not taxed. If you receive money earmarked for medical expenses, like out-of-pocket medical costs or unpaid medical bills, those payments are not taxed.
Lost wages are typically not taxable either if they arise out of the personal injuries. This includes both past and future lost wages. This one can get tricky so it is important to run it by your accountant.
Funds received for emotional injuries and punitive damages merit special discussion. First, punitive damages are always taxed in full. Emotional damages are tax free to a degree but are taxable in certain situations.
Settlement payments for emotional distress caused by the physical injury are tax-free as well up to the point. Emotional distress is treated as arising out of the physical personal injuries. This one too can get a little dicey since there are limits to the amount of emotional damages that are tax free. Specifically, the emotional damages are probably only tax free up the amount of medical expenses expended on treating those emotional injuries and are only tax free to the degree they were caused by the physical injuries.
It is important to discuss these issues with your attorney. You don’t want to underpay but neither do you want to overpay. As such, it is equally important to discuss them with your accountant to make sure that they are properly accounted for on your taxes.