Typically, compensation received from your personal injury settlement is not taxable; however, some exceptions do apply. In other words, the general rule is that settlement proceeds are non-taxable. Money received through your bodily injury settlement is generally not taxable because the settlement largely encompasses reimbursements (i.e., medical expenses and miscellaneous out-of-pocket expenses). With this being said, to every rule there are exceptions; therefore, this article will focus on key situations where portions of your bodily injury settlement may be taxable.
Provided below is a list of a few exceptions where you may be taxed on portions of your personal injury settlement or award. Please keep in mind that this is by no means an exhaustive list, and we always recommend that you speak with your certified public accountant or a tax attorney concerning what exactly what may or may not be taxable.
Generally speaking, any lost wages reimbursed through your bodily injury settlement or award will need to be claimed on your taxes as income. Therefore, if you receive reimbursement for lost wages and they are itemized as such through your settlement or award, then they should be considered taxable wages and are subject to both federal and state income tax rates. With this being said, you should always follow up with a tax attorney or a certified public accountant before filing your taxes to make determine whether portions of your settlement proceeds will be subject to income tax.
Important Note: If you are an entrepreneur/self-employed and you are reimbursed for lost profits or opportunities for your business, portions of this reimbursement could also be subject to taxation. Generally, lost profits should be included as business income; however, it is important that you get advice from your business accountant, as all the proceeds may not be subject to the same tax.
Again, the general rule is that medical expenses reimbursed or covered within your bodily injury settlement should not be taxed. However, with this being said, there are exceptions. The main exception applies when you have taken a deduction for a medical expense related to your bodily injury claim in any prior year(s) to your settlement or award.
With this being said, the medical expenses will only be taxed to the extent of the tax benefit. Therefore, it is important that you include any reimbursements for those medical expenses as income if you have taken such deductions. Let’s look at the following example, which will help to further illustrate the medical deduction exception.
Let’s assume that you were in an accident in 2014 and spent $3,000 on medical expenses for the injuries you sustained. When filing your taxes for the year, you take a deduction for the $3,000. In 2015, you receive a settlement for your bodily injury claim where you were reimbursed the $3,000 in full. Because you have already received a tax deduction for the medical expenses, you must claim the amount of the tax benefit as income.
Important Note: When taking a deduction, you are not credited with the full amount claimed on the deduction. A deduction typically reduces your taxable income by a certain percentage point. Therefore, you will not likely need to claim the full $3,000, only the benefit received from the previous medical reduction. Therefore, it is very important that you speak with your accountant or a tax attorney before filing your income taxes.
While rare, you may receive interest on a bodily injury judgment. This may occur in situations where you have had to resolve your bodily injury claim through the court system. With this being said, any interest received on your bodily injury claim must be included as interest income.
Punitive damages are rare in bodily injury awards; however, they are available in certain situations. If you do receive a punitive damage award, then it should be included as “other income” when filing your income taxes. Punitive awards will almost always be taxed and therefore should be included when filing your income taxes.
We cannot stress enough the importance of speaking with a certified public accountant or a tax attorney before filing your tax returns if you have received a bodily injury settlement or award within the taxable year. If you would like more detailed information regarding what should or should not be included on your income taxes, please visit IRS Publication 525.