So you were injured in a car accident and you have received a settlement or judgement with compensation for your injuries and damages. But what about when tax season comes up? Where does your lawsuit settlement fit in and how will you be taxed? Below are some key things to remember:
Settlements and Judgement Will Be Taxed the Same
The same state and federal tax rules apply to you whether you win a judgement or settlement. But you will generally have more flexibility to reduce your taxes owed if the case is a settlement. If you ever are audited, you will need to show the agreement for the settlement, 1099s, the complaint, checks, etc. You can have an effect on how the recovery is taxed by how you deal with these.
Recoveries for Personal Physical Injuries and Illnesses Are Free of Tax
If you file a lawsuit or claim for physical injuries and illnesses that arise from a car accident, you will get your settlement or judgement without any taxation. The key however is that you must be filing a claim or suit for physical injuries stemming from the car accident. If you receive a settlement for emotional distress or mental anguish, this is taxable as income. There was a time when all personal damages were free of tax but this was changed in 1996. You can be taxed at both the federal and state levels for injuries that are not related to actual physical injuries.
Medical Expenses Are Free of Tax
While you do have to pay taxes on mental and emotional anguish compensation in your settlement or lawsuit, payments for all medical expenses are all tax free. So, if you have to visit a psychiatrist or counselor to deal with the aftermath of your accident, any money you get in compensation will not be taxed at the state or federal level. Many nontraditional medical treatments may qualify as well, such as acupuncture.
Punitive Damages Are Always Taxable
Punitive damages are those that are levied against the defendant for actions that were truly reckless and dangerous. The purpose of these damages is to punish the defendant. Punitive damages are not compensation to you for your injuries. So, punitive damages, if they are awarded to you, are always taxable as income.
Attorney Fees Can Be a Tax Trap
It is important to factor in the cost of your personal injury attorney when you are dealing with taxes after a settlement. Most personal injury attorneys are paid by contingency fee. For tax purposes, you usually are treated as receiving 100% of the settlement, even if the defendant has to pay your attorney his 33% contingency fee. If the case is fully nontaxable, then you will not have any tax issues. But if the recovery can be taxed in any way, it is important to get tax advice from an expert.
It always is advisable to have a tax professional review your settlement or judgement to ensure that you do not get hit with a nasty tax surprise during the next tax season.