We are in a new year and tax season is just around the corner. Because of this, if you have received a personal injury settlement or award it is important that you understand all the tax ramifications before filing your tax returns. Years ago I incorrectly thought that a personal injury settlement or award was simply not taxable. But this isn’t completely accurate.
So let’s begin with Personal Injury 101. If you are injured in an accident, you are actually entitled to many different kinds of damages in relation to your actual injury, which include compensation for your medical bills, pain and suffering, lost income, and interest accrued on an award that is appealed by the at-fault party. As crazy as it seems, the IRS actually differentiates between theses different types of awards and taxes them differently.
Tax Tip #1: Money for Pain and Suffering
The best way to look at the money that you are being paid for “pain and suffering” is that this is the actual money being paid to you for your physical injury. Currently, according to the IRS compensation that a person is paid for physical injury is federal-income-tax-free. It doesn’t matter if the money is from a settlement or actually from a award after filing a lawsuit. Compensation for emotional distress is also tax-free because it is considered to be part of your physical injury.
Tax Tip #2: Money for Medical Expenses
Money paid to you in order to cover your medical expenses are tax-free too. However, if you claim a tax deduction for accident related medical expenses and you are later reimbursed for those same medical expenses as part of your case, you must “recapture” that amount and will have to pay tax on it because you previously benefited from the deduction that you took. If your settlement or award does not specifically allocate an amount for medical expenses and you previously took a tax deduction for your accident related medical expenses, the award or settlement is automatically considered to be a reimbursement for such expenses up to the amount of those expenses.
So the key here is the tax deduction. If you did not take a deduction for these medical expenses than this award is tax-free, if you did benefit from the taking of a tax deduction that you will need to report these amounts on your taxes after your settlement or award is received.
Tax Tip #3: Interest Paid on an Award
Generally interest will not be part of a settlement, but could be part of an award that is then appealed. Having said that, if any part of your award or settlement is deemed to be interest, that part is taxable.
Tax Tip #4: Reimbursement for Lost Wages
Oddly enough, amounts paid for lost wages are federal-income-tax-free, even though the wages would have been taxable if you had received them.
Example: Let’s say you were injured in a car accident is 2015. In that accident you had $25,000 in medical bills and expenses and $10,000 in lost wages. On your 2015 and 2016 returns, you claimed medical expense deductions totaling $12,000. You eventually receive a $150,000 out-of-court settlement that covers medical expenses, lost wages, pain and suffering, and $5,000 for interest. Only $17,000 is taxable ($12,000 for the medical expenses that were previously deducted and then reimbursed and the $5,000 for interest). The remaining $133,000 ($150,000 minus $12,000 minus $5000) is free from federal income tax.
Tax Tip #5: What About Attorney’s Fees?
You cannot deduct attorney fees incurred to collect a tax-free award or settlement for physical injury or sickness. In other words, no deductions are allowed for fees to collect tax-free compensation.
After that, the rules change and are not so favorable. Let’s say part of your award or settlement is tax-free (for physical injury and wage loss), and part is taxable (for interest). As a general rule, you must report the full amount of the taxable portion of the award or settlement as income on your return, without any reduction for the related attorney fees. Then, you can treat the fees related to the taxable portion as a miscellaneous itemized deduction item on Schedule A of your Form 1040. Calculate the deduction by multiplying the total fees by a fraction. The numerator is the taxable portion of your award or settlement, and the denominator is the total amount of the award or settlement.
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