Whether you’ve had an accident at work or suffering after an injury, you can often receive compensation if it wasn’t your fault. Generally, compensation for your pain and suffering is not taxable.
However, specific portions of your settlement such as reimbursement of your wages may be subject to income tax. Once you receive your payment, the federal government will have access to your compensation information.
If you fail to report a portion of your compensation on your tax report, you may be subjected to some penalties.
These penalties can be just as severe as if you don’t report any other income. You can’t escape the federal government, we recommend being as honest and open as possible.
Once you receive your payment, it may or may not already be broken down into portions. The breakdown can be hard to read and it can be difficult to work out what you need to pay tax on.
Also, insurance companies will usually pay out a lump sum for medical expenses, lost wages, and pain and suffering. They’ll then often leave it to you to work out what portions are taxable.
Categorizing these funds is subjective, so the Internal Revenue Service traditionally hasn’t considered enforcing settlement taxes as a priority. However, you should be aware that if you fail to pay any income tax on portions you’re required to pay, this could trigger an audit.
What about any deductions?
Generally speaking, when people start looking into taxes, they also want to know about any deductions. All personal injury settlements include reimbursement for medical expenses. Strictly speaking, this money is not taxable.
It only becomes taxable if you deduct those same medical expenses on your tax return. You can only deduct something as an expense if you don’t get reimbursed for it.
IRS Code 213 defines qualifying medical costs as follows, “These medical expenses incurred to diagnose, cure, treat, mitigate, or prevent a disease, or for the purpose of affecting any structure or function of the body.”
In layman’s terms, you only pay taxes on your settlement if you’ve already deducted the expense. A portion of general medical expenses is tax-deductible, but only if you do not get reimbursed for them.
If you have previously deducted these costs on a recently filed tax return but still received compensation to cover those costs, you’ll have to pay income tax on that portion of your settlement funds.
Essentially, if you deduct these costs on your tax return as an expense but then get paid back for the same cost from the settlement, then they’re no longer an expense.
So, when you receive your settlement, consider whether you’ve already taken a tax deduction for medical costs. If you have, consider setting aside a minimum of a third of the total amount of your settlement money to pay this income tax just in case.
Why does the IRS tax these expenses?
According to the IRS, the reason is simple. You paid for medical treatment out of your own pocket while your injury claim was pending and then took the associated tax deduction.
When you settled your claim, the settlement included reimbursement from the insurance company for those same deductions. The amount is considered to be income because it’s not money to reimburse you for your injuries or pain and suffering.
The funds are reimbursement for the money you paid to the medical care providers, and since you’ve already deduced that amount on your previous tax return, the IRS considers the amount you received in your settlement as ordinary income.
If you haven’t deducted those medical expenses on your previous tax return, then you will be able to keep the total amount specifically representing those costs.
It’s important to keep in mind that many states in the US have their own income tax requirements.
Check with your state tax authority if any part of your settlement is taxable, especially the portion paid for lost income. Even better, have an experienced accountant to review your tax return.
What about taxes on lost income?
Most bodily injury settlements include reimbursement for lost income. It’s likely that your settlement includes some amount for your lost wages. You’ll have to pay income tax on that other amount, the same way you would for any employment earnings.
The IRS considers it ordinary income. To be safe, put aside a third of your settlement for lost income. Alternatively, if you already know your income tax rate, set aside that amount so it’s available when you file your tax return.
The IRS will find out about your settlement, and it’s straightforward for them to determine the amount of compensation paid to you for lost wages. To be in compliance with federal law, you must list the amount of your reimbursed income on your federal tax return.
Pain and suffering
Pain and suffering are separate from the loss of earnings and medical expenses. Emotional suffering and stress are usually not taxable. The IRS considers such payments reimbursement for your actual injuries.
A physical injury can be explained in medical terms. However, emotional damage can be difficult to determine.
Keep in mind that if you’ve been awarded compensation for anything other than a physical injury, such as an injury to character, that money is taxable. Check IRS Publication 525 for more specific information on this topic.
The IRS does not consider punitive damages to be the same as pain and suffering or emotional distress. You probably don’t have to worry about this, however, as the majority of personal injury settlements do not include punitive damages.
If you were awarded punitive damages as part of your settlement, that amount is considered taxable income and should be reported on your 1040. It can get pretty confusing, so if something stops making sense, it’s a good idea to start speaking to an expert.
If you have any questions about paying taxes on your settlement, talk to a professional, or contact the IRS directly.
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