How Much Tax Is Paid on Lawsuit Settlements or Awards?
You might have recently secured a settlement from a personal injury lawsuit. The money goes toward your medical bills and other expenses. However, you might wonder whether it will affect your tax return when it’s time to file in April. You should understand the potential tax implications of recovering personal injury compensation to help prepare for your financial future.
Are There State Taxes on Settlements?
You don’t have to pay state taxes on your lawsuit settlement or jury verdict in Texas. The state does not have an income tax. Instead, it collects revenue from property, sales, and use taxes. The Texas Constitution also prohibits the state government from establishing an income tax.
Understanding Federal Taxes for Actual Losses
The Internal Revenue Service (IRS) cannot tax most of the money someone recovers as part of a court award or settlement. That means you don’t have to pay taxes on personal injury compensation you receive for your:
- Loss of quality of life
- Hospital and doctor’s bills
- Pain and suffering
- Expenses to improve accessibility at home
- Physical therapy and rehabilitation
The settlement must directly relate to your physical injury. Otherwise, the IRS will consider it taxable income. That means the money you collect must compensate you for your actual losses. The IRS can tax you on it if it’s for emotional distress you experienced from something other than your physical injury.
Federal Taxes and Punitive Damages
The judge or jury might have awarded you punitive damages if your case went to trial. Punitive damages punish the defendant for their actions and are meant to deter similar behavior in the future. This award does not compensate the plaintiff for actual losses.
Since punitive damages are not considered payment for actual losses, they aren’t related to your physical injury. That means the IRS can impose taxes on the financial award.
Are Lost Wages Subject to a Federal Tax?
No. Lost wages are considered part of your accident-related losses. Any recovery you get for income you missed out on because your injuries prevented you from working is considered economic compensation. The portion of your settlement that is economic compensation is not subject to federal income tax.
How Interest Might Apply to a Personal Injury Settlement
The insurer might not pay out immediately after you secure a settlement or jury verdict from a lawsuit. If that happens, you will owe interest on the initial financial award. Federal taxes apply to the interest on court-awarded damages or settlements in this situation. It’s similar to the interest on a certificate of deposit (CD), savings account, or loan.
Preparing Your Settlement for Federal Taxes
You can consult a personal injury attorney to determine which parts of your settlement are taxable. You must list each one correctly when you file your taxes with the IRS. You’ll have to break the separate portions of your settlement apart for purposes of your tax return. Whether an amount is taxable depends on the type of compensation:
- Actual losses – You can exclude payments for actual losses from your tax return and income if they relate to your physical injury (except compensation for wages).
- Wages – The portion of your settlement or award that is compensation for wages you were unable to earn because of your injury must be reported as income.
- Interest – You must report interest from your settlement as Interest Income on Form 1040.
- Punitive damages – Punitive damages also go under Other Income on Form 1040 Schedule 1.
Consult The Benton Law Firm About Your Personal Injury Settlement
Settling or winning a verdict in a personal injury case is exciting. You can finally breathe a sigh of relief and put this traumatic experience behind you. However, your work isn’t over yet. You might owe taxes on your compensation under specific circumstances.
At The Benton Law Firm, our Dallas personal injury attorneys believe in advocating for victims of others’ wrongdoing. You won’t be alone in the fight to hold the negligent party liable for their misconduct. You will be our priority and receive ongoing support and quality legal representation until the end.
If you sustained injuries in an accident due to someone else’s negligent actions, call us at (214) 777-7777 for a free consultation. We will aggressively seek the compensation you are entitled to and try to achieve a favorable result for you.