As an accident victim, you’ve been through a lot. Hospital stays, doctor’s appointments, missed work, not to mention the pain, suffering, and uncertainty about the future you have endured.
When you finally receive word that the insurance company agreed to settle your case, it is a light at the end of the tunnel.
However, before you pay off all your medical bills and make arrangements for the rest of the settlement proceeds, it is important to understand if your personal injury settlement is taxable.
So read on if you are wondering, When is a personal injury settlement taxable?
Are Personal Injury Settlements Taxable Under Federal Law?
Are personal injury settlements taxable? The answer to this question is not always straightforward.
As a general rule, portions of a personal injury settlement are taxable, while other portions are not taxable.
Most personal injury settlements are made up of various damages awards intended to compensate you for specific harms.
Below is a list of the most commonly awarded damages and a discussion about when the settlement proceeds are taxable.
Under federal tax law, any portion of a personal injury settlement related to past or future medical expenses is not taxable.
However, if you took an itemized deduction for the expenses, you must include the portion you claimed if doing so provided you with a tax benefit.
Additionally, suppose the proceeds are for medical expenses you paid over more than one tax year.
In that case, you must prorate part of the proceeds for medical expenses to each of the years you paid medical expenses.
Lost wages awards compensate you for the money that you didn’t earn because of your injuries. Similarly, you may also receive compensation if the incident resulted in a decrease in future earning capacity.
This applies, for instance, if your injuries render you unable to return to the job you had before the accident.
If your personal injury settlement includes an award for lost wages, you must pay taxes on that portion of the settlement. This makes sense because you would need to pay taxes on your wages had you been able to work.
Non-economic damages compensate you for the psychological and emotional impact the accident had on your life. In cases involving severe, life-changing injuries, non-economic damages can be substantial.
Generally, most people will not need to pay taxes on the non-economic damages portion of their settlement.
However, if you recovered non-economic damages that “did not originate from a personal physical injury or physical sickness,” you must include them as income.
An example of taxable non-economic damages is if you recover compensation due to the emotional trauma of witnessing a loved one’s death.
If you need to pay taxes on non-economic damages, you can exclude any portion that you used to pay for related medical expenses not previously deducted.
Whether you need to pay taxes on settlement proceeds related to property damage depends on the extent of the damage compared to your cost basis on the property.
For example, losses that are less than the adjusted cost basis of your property are not taxed.
However, you must reduce your cost basis by the amount of compensation received. If the settlement exceeds your adjusted basis, the excess amount is considered income.
Punitive damages are meant to punish a defendant for their particularly egregious misconduct and discourage others from engaging in similar behavior.
Punitive damages are rare, especially in a settlement. But when they are awarded, they tend to be significant. The IRS considers punitive damages as taxable income.
One additional thing to consider is how the insurance company structures a settlement award.
Typically, insurance companies are willing to structure a settlement such that it minimizes—but does not eliminate—an accident victim’s tax burden, within reason.
Of course, this must be done with care so as to not run afoul of the tax laws. An experienced California personal injury lawyer can help accident victims determine the best way to structure a settlement.
If you agree to a confidentiality agreement as part of your settlement, be careful. A confidentiality agreement might make your personal injury settlement taxable.
Whenever there is a confidentiality agreement, it is important to clarify which part of the settlement is for the confidentiality agreement and which part is for the personal injury settlement.
Are Personal Injury Settlements Taxable in California?
No, as a general rule, California does not impose taxes on personal injury settlements. Of course, you should always double-check with the person who prepares your taxes to be sure.
Are You Hoping for a Personal Injury Settlement?
If you or a loved one was recently injured in an accident, you might be entitled to financial compensation through a personal injury claim.
At Wells Call Injury Lawyers, our dedicated team of attorneys has over 40 years of experience aggressively pursuing compensation on behalf of our clients.
Over this time, we’ve recovered hundreds of millions of dollars for our clients, enabling them to move on more easily after a life-changing accident.
We take an individualized approach to every client we help, ensuring that we address the issues most important to them and their families.