You pay income tax on more than just your paycheck. IRS Publication 525 lists all the different types of income, such as fringe benefits, bribes and cash rebates, and lists which ones are taxable. If your doctor screws up and you sue, some or all of your settlement may be tax-free, but it's not guaranteed.
Damages that compensate you for any physical injury you suffered from the malpractice aren't taxable. Money to pay your medical bills and costs are also tax-free, including visits to a psychiatrist because of trauma. Unfortunately, this only applies to medical bills you've already incurred. If the court awards you money for treatment down the road, you're going to have to pay tax on it. The same rules apply whether you win in court or settle outside of it.
Punitive damages are always taxable. Usually "emotional distress" awards are too. Lost wages are iffy. Normally, money to cover lost work is taxable, just like wages. If you can't work because of a botched operation, say, and the lost wages are compensation for the injury, it may be tax-free. If you're not sure how your particular settlement breaks down, ask your lawyer to spell it out for you so you know what part you pay the IRS for.
If your settlement includes a payment to cover your legal fees and court costs, that money may be taxable. If your settlement is tax-free, so is your fee payment; if you won punitive damages, you owe tax if the doctor paid your court fees. A settlement that mixes both types requires prorating fees. If, say, 83 percent of your settlement is taxable, so is 83 percent of the money you were given to pay the attorneys.
You report your total income on Line 21 of Form 1040, as "other income." You can write off your legal fees for the case as a 2 percent deduction on Schedule A if you itemize. Add up all the deductions in this category, subtract 2 percent of your adjusted gross income, then write off what's left. If the settlement reimburses you for medical bills you already wrote off as an expense, the reimbursement is taxable the year you receive it.
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