Recovering after an accident is challenging, especially if you have extensive injuries. Unfortunately, your medical bills pile up while you wait to receive your compensation. Even then, some of the money might go to the IRS (Internal Revenue Service), making you wonder how much of your personal injury settlement is taxable.
You can receive various payments for your personal injury settlement, considering the type of accident and the damages you suffered. Brown-gessell.com states that in the case of a car crash, your settlement payments might include medical bills, lost wages, emotional distress, property damage, and attorney’s fees.
In California, some of your compensation could be taxable depending on your circumstances. Having a lawyer to help you determine which solutions will work best for your case can be a lifesaver. If you must fill out the tax-return report and need help figuring out how to complete it correctly, the following points might be helpful to you.
Medical Bills and Lost Wages
Although personal injury settlements are tax-free in most cases, there are a few exceptions, including your medical bills. Your medical expenses would be tax-free only if you did not take an itemized deduction in previous years. Itemized deductions can decrease your taxable income, and you can claim this sum on your tax return. You might have added an itemized deduction to your taxes when you paid for medical expenses for more than a year. In this case, you will have to pay a pro-rata tax on the medical expenses you listed as deductions.
Even though your injuries might have cost you some wages, you can receive compensation to cover your losses. But it will not be tax-free. Although the lost wages were directly caused by your inability to work after the accident, the IRS considers that you would have paid Social Security and Medicare taxes if you could work. The taxes will be calculated based on the typical pay on your income.
Non-Economic Damages and Punitive Damages
Being involved in an accident can be traumatic. You could suffer from emotional distress if you have signs of emotional distress, such as stomachaches and headaches. Depending on your circumstances, you might be eligible for emotional distress damages compensation. Damages for mental anguish are not taxable as long as these damages come from a physical injury or sickness. In this case, any medical expenses related to your emotional distress will be tax-exempt. In some instances, your counseling sessions are included in the settlement.
One could sue for punitive damages if the accident’s cause were the driver’s reckless behavior, leading to injury or death. Punitive damages are meant to punish the guilty party monetarily and not to compensate the victim. The court rarely awards punitive damages on top of the compensation, but expect to pay taxes if it happens in your case.
How the IRS Collects Settlement Taxes
To avoid receiving any penalties for late payments, you need to report your situation to the IRS by filing a tax return for the preceding year. If you received compensation for your physical injuries, you do not need to report it as an income. If you were awarded punitive damages, you would have to file them as an income. Lastly, include in the tax return form all the lost wages you received in a settlement.
According to the IRS’s Settlements – Taxability guide, part of the amount received as compensation will be taxed just like income. Having an accountant when filling out a complicated tax-return form will ensure you avoid making costly mistakes.
Veeramachineni Lalitha
I am Finance Content Writer. I write Personal Finance, banking, investment, and insurance related content for top clients including Kotak Mahindra Bank, Edelweiss, ICICI BANK and IDFC FIRST Bank. My experience details : Linkedin