After a serious crash, receiving a personal injury settlement can feel like a huge relief: a chance to pay medical bills, cover lost wages, and move forward. But before you spend that money, it’s important to understand how the Internal Revenue Service (IRS) treats these settlements. Is it all tax-free? Not exactly. Some portions are non-taxable, but others can increase your tax burden significantly.
Documented Expenses
“IRC Section 104 provides an exclusion from taxable income with respect to lawsuits, settlements and awards. However, the facts and circumstances surrounding each settlement payment must be considered to determine the purpose for which the money was received because not all amounts received from a settlement are exempt from taxes.”
Under the Internal Revenue Code, most personal injury settlements for physical injuries are not taxable. This includes compensation for your hospital bills, physical therapy, surgeries, and other medical treatments. Damages for pain and suffering or emotional distress are also generally excluded from income, as long as they’re directly connected to a physical injury.
In addition, if your attorney’s fees are deducted from the non-taxable portion of your settlement, those legal costs aren’t taxable either. This often arises in cases involving confidential settlements, where both parties agree not to disclose the terms but still require a clear tax classification.
Lost Income And Other Taxable Amounts – 26 U.S. Code § 104 – Compensation for injuries or sickness
However, not all compensation is treated equally. If your personal injury settlement includes damages for lost wages, that amount is typically taxed. Why? Because wages would have been taxed if you had earned them normally. The IRS sees no difference.
Another taxable category is punitive damages, which are awarded to punish especially reckless or intentional behavior. Though rare in auto accident cases, these damages are always taxable. The same goes for interest that accrues on a settlement or court award between the time your case is resolved and the time payment is made. That interest is treated as income and reported accordingly.
Compensation for property damage is more nuanced. If you receive money for repairs or to replace your vehicle, and the amount doesn’t exceed your car’s adjusted value, it’s not taxable. However, if the reimbursement exceeds the vehicle’s worth, the excess may be considered taxable income.
Non-Economic Damages
Emotional distress also presents a gray area. If it stems from a physical injury, like anxiety or PTSD after a serious crash, the settlement is usually tax-exempt. But if you experienced emotional trauma without any physical harm, such as witnessing an accident or seeing a loved one injured, compensation for that suffering may be taxable.
While the general rule is that physical injury settlements are not taxed, most claims are complex. They often combine different types of compensation: medical bills, emotional distress, lost wages, and more, which makes the tax implications far from straightforward.
How A Lawyer Can Help?
In Washington State, for example, many types of personal injury cases fall under the non-taxable umbrella: car and truck accidents, boating collisions, dog bites, slip-and-fall incidents, workplace injuries, defective products or medications, and even wrongful death claims. But any case that includes punitive damages, interest, or compensation unrelated to a physical injury could have taxable components.
A vague or poorly structured settlement can make it harder to determine what’s taxable and what isn’t. That’s why we always recommend consulting with a qualified attorney and, in some cases, a tax professional. Getting it right the first time can help you avoid unexpected surprises later, particularly during tax season.
An Advocate Can Get The Compensation You Deserve
At The Advocates, we guide injured people not just through the legal process, but also through the financial implications of their settlements. We know how important it is to protect what you’ve fought for, and that includes understanding your rights under the Internal Revenue Code and managing your potential tax burden wisely.
Have questions about how your compensation might be taxed? Reach out today. Your consultation is always free, and we’ll help you move forward with clarity and peace of mind.