Receiving an injury settlement means that you suffered harm, so you might think that the government should not expect a share. Depending on the type of settlement you receive, you are right. While no one wants to experience the harm that leads up to an injury settlement, knowing the tax implications of an award might help ease some of the stress associated with dealing with the Internal Revenue Service.
If your settlement is related to a physical injury or sickness, the income is not taxable, according to the IRS. Regardless of whether you receive the income through settlement or through court order, or as periodic payments or as a lump-sum payment, the income is not taxable, according to 26 U.S. Code § 104. This includes any amounts awarded for lost wages, emotional distress and medical expenses because of the injury.
Before 1996, settlements for nonphysical injuries were not taxable. In August of that year, the government amended the code dealing with settlement income taxes -- 26 USC § 104 -- making any settlement income because of an emotional illness such as depression or post-traumatic stress disorder taxable, unless the illness arose because of a physical injury. The only exception is any portion of the settlement used to pay out-of-pocket medical expenses.
If the settlement -- or part of it -- reimburses you for medical expenses you have already deducted from your taxes, it is taxable up to the amount of your previous deduction. For example, if you deducted $20,000 for medical expenses stemming from a physical injury and two years later you receive a $30,000 settlement, $20,000 of the settlement is taxable and $10,000 is not. If you did not deduct your medical expenses, the full $30,000 is not taxable income.
As for attorney fees, the news is bad, good, and -- sometimes -- bad again. You cannot deduct the fees you pay to an attorney if the entire settlement is tax-free. However, if a portion of your settlement is taxable, the IRS allows you to deduct any fees you incur collecting the settlement, as a miscellaneous deduction. The last bad news is that because miscellaneous deductions are subject to a two-percent limit of adjusted gross incomes, you might not have much of a deduction. For example, if your adjusted gross income -- including the settlement income -- is $30,000 and your attorney fee is $1,000, only $400 of the fee is deductible because the first $600 is less than 2 percent of your adjusted gross income.
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