Is the Money from a Personal Injury Settlement Subject to Tax?

Just in time for the tax filing deadline: You’ve gone through the litigation and your personal injury lawyer has successfully secured a settlement for you the previous tax year. Your question: is this money mine in entirety? What are the most common scenarios and is the money from a personal injury settlement taxable?

Ordinarily No…

In general, the money that is received from a personal injury settlement is not taxable as long as it was received due to a physical injury or physical sickness. The IRS states that:

If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income. (IRS)

In short, if you did not claim a deduction on the medical bills, which resulted from the injury or illness, the settlement money is all yours.

However, there are circumstances, which deem personal injury settlement cash taxable.

When is my settlement considered taxable?

In general, the Internal Revenue Service (IRS) will only seek to tax personal injury settlements if the settlement is meant to replace your own income.

Income Replacement:

In the event that your settlement is meant to replace income (e.g. employment discrimination or a lost profits claim from business) then the claim can be taxed. There are a few other instances that may be considered income replacement, so if this is something that you are worried about, it is important to consult a tax attorney to determine whether your settlement is taxable based on the unique circumstances of your case.

If your personal injury settlement is compensation for a physical observable injury, then the general rule is it will not be taxable. However, those are difficult quantifiers if the injury may be internal or mental.

Medical Deductions Have Been Performed:

The other specific instance where your personal injury settlement may be taxed is in the event that you have previously claimed medical expenses. According to Tax Attorney John Claudell: “if you itemize deductions and you claimed medical expenses in previous years as an itemized deduction that were later reimbursed by the settlement then that amount would be taxable.”

Essentially what the IRS is saying here is that if you have claimed the money as a deduction from your taxes previously then there is the chance that the personal injury settlement you have received will be taxed. The exact wording from the IRS website is as follows:

If you receive a settlement for personal physical injuries or physical sickness, you must include in income that portion of the settlement that is for medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit. If part of the proceeds is for medical expenses you paid in more than one year, you must allocate on a pro rata basis the part of the proceeds for medical expenses to each of the years you paid medical expenses. See Recoveries in Publication 525 for details on how to calculate the amount to report. The tax benefit amount should be reported as “Other Income” on line 21 of Form 1040.

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