When your case finally settles, it can feel like a huge weight has been lifted. But as you begin to think about the next steps, like paying medical bills, replacing lost income, or simply rebuilding your life, another worry might creep in: Are personal injury settlements taxable by the IRS?
It is a common and understandable concern. After all, the settlement represents justice for what you’ve gone through. The last thing you want is uncertainty about whether you get to keep the full amount. Many in your position ask the same question: Are personal injury settlements taxable?
Having the right guidance matters. Marker Law, LLC, a Naperville-based personal injury and workers’ compensation law firm with over 25 years of experience, helps clients recover fair compensation and understand the rules that affect how much recovery stays in their pocket.
This article will explain which parts of a personal injury settlement are taxable and which are not, and how you can protect your financial recovery under federal and Illinois law.
Contact us today at 331-295-8005 to discuss your case and learn how we can help you.
Do You Pay Taxes on Personal Injury Settlements?
Under federal and Illinois state laws, the general rule is that compensation for physical injuries or illnesses is not taxable. If you receive money for medical expenses, lost quality of life, or pain and suffering directly tied to a physical injury, you usually will not have to pay taxes on it.
However, not every payment you receive from your claim will fall into the nontaxable category. Some portions may be subject to tax, depending on what they compensate.
What Is Taxable?
While most physical injury compensation is exempt from income tax, certain parts of a settlement are taxable. The IRS focuses on the origin of the claim and the reason the payment was made. If the payment replaces something that would have been taxable, it is also likely taxable.
Lost Wages
When you are injured and cannot work, a settlement may include money to replace the income you missed during your recovery. The IRS views this type of compensation as it views your paycheck. In other words, because you would have paid income tax on those wages had you earned them, you must also pay income tax on the settlement money that replaces them.
Future Earnings
If your settlement includes damages for reduced earning capacity or future lost wages, the IRS also treats this money as taxable. The reasoning is the same: the money is intended to replace income that would have been taxed had you continued working.
Emotional Distress Unrelated to the Physical Injury
When emotional distress or mental anguish stems from a physical injury, the compensation is generally not taxable. However, it is taxable if the emotional distress is unrelated to a physical injury.
Punitive Damages
Punitive damages are intended to punish the defendant for egregious behavior rather than to compensate you for losses. The IRS considers these taxable in all cases, even when they are awarded in connection with a physical injury.
Interest
Sometimes a settlement includes interest that accrues between the time a verdict or settlement is reached and the time payment is made. This interest is taxable because it is considered income, not compensation for your injury.
What Is Non-Taxable?
The parts of a settlement that directly compensate you for physical injuries and related losses are usually exempt from federal and Illinois state income taxes.
Compensation for Medical Expenses
A large portion of most personal injury settlements goes toward covering medical expenses, including the cost of emergency care, surgeries, rehabilitation, physical therapy, medication, or other treatment connected to the injury. This type of compensation is generally nontaxable because it is considered reimbursement for the costs you incurred because of your injury.
Pain and Suffering Damages
Compensation for pain and suffering connected to a physical injury is not taxable. These damages are meant to acknowledge the physical discomfort, limitations, and overall impact the injury has on your daily life. Since they stem directly from the injury, the IRS and Illinois law treat them the same way: as reimbursement for harm suffered, not as taxable income.
Property Damage
If your case involves damage to personal property, such as a vehicle in a car accident, compensation for repairs or replacement is generally not taxable. The only exception is when the payment exceeds the adjusted basis of the property, in which case the excess amount could be taxable.
FAQs
Here are some common questions we are often asked regarding how personal injury settlements are taxed.
Do I Have to Report Personal Injury Settlement to IRS?
Yes. You must report the taxable portions of your personal injury settlement, such as punitive damages, lost wages, or interest. The IRS may require documentation showing how the settlement amount is allocated.
Do I Have to Declare Personal Injury Compensation?
If the compensation is for physical injuries and medical expenses, you typically do not need to declare it as income. Taxable portions, however, must be declared. The IRS considers lost wages, loss of future earning capacity, and punitive damages taxable and, therefore, must be declared.
How to Avoid Paying Taxes on Settlement Money
You cannot avoid paying taxes on settlement money. Certain parts of a settlement, like lost wages or punitive damages, are taxable. However, you can avoid unnecessary taxes by ensuring your settlement agreement clearly explains how the money is divided. A breakdown specifying how much the settlement is for medical expenses, lost income, pain and suffering, or property damage can make a big difference.
Get Help Understanding What Portions of Your Personal Injury Settlement Are Taxable
Knowing which parts of your personal injury settlement are taxable is essential. Clear settlement agreements, careful allocation of damages, and informed legal guidance can help you preserve more of your recovery.
Marker Law, LLC has been recognized by Super Lawyers for over a decade. With deep roots in the Naperville community and strong relationships with local judges, doctors, and other attorneys, the firm is known for its direct access to attorneys, commitment to client care, and ability to secure results.
If you have questions or need an advocate to guide you through the settlement process, contact Marker Law, LLC today for a free consultation.