After months of treatment and negotiation, a settlement finally arrives. Then comes the question almost every client asks: will the IRS take a piece? For most physical injury cases, the answer is good news. But some parts of a settlement can be taxed, and how the settlement is worded can matter.

The short version

  • Money for physical injuries or physical sickness is generally not taxable under federal law (26 U.S.C. § 104(a)(2)).
  • Punitive damages and interest are generally taxable.
  • Emotional distress damages are taxable unless they come from a physical injury.
  • New Jersey generally follows the same approach for state income tax on physical injury damages.

The federal rule: physical injuries are excluded

Section 104(a)(2) of the Internal Revenue Code excludes from gross income "the amount of any damages (other than punitive damages) received ... on account of personal physical injuries or physical sickness." The IRS explains this in Publication 4345, Settlements — Taxability. In a typical car crash, truck accident, slip-and-fall, or medical malpractice case, the money for pain and suffering, medical bills, and lost wages that flows from the physical injury is generally not taxable.

Yes, even the lost wages

This surprises many people. In an ordinary paycheck, wages are taxed. But when lost wages are recovered because of a physical injury in a personal injury case, they're generally part of the excluded damages.

What can be taxed

Punitive damages

Punitive damages punish the defendant rather than compensate you, so the IRS treats them as taxable income. They come up in cases involving drunk drivers and other reckless conduct. Read about punitive damages in New Jersey.

Interest

Interest on a judgment is generally taxable. New Jersey courts can add prejudgment interest in tort cases under Court Rule 4:42-11(b). That portion is treated as interest, not as injury damages.

Emotional distress without physical injury

Damages for emotional distress alone, for example in an employment or defamation case, are generally taxable. Emotional distress that flows from a physical injury is treated as part of the physical injury recovery.

Medical expenses you already deducted

If you deducted medical expenses on a prior tax return and then were reimbursed for them in the settlement, that portion may be taxable to the extent the deduction gave you a tax benefit.

Wrongful death settlements

Wrongful death damages generally arise from a physical injury, the one that caused the death, so they're generally excluded as well. Punitive damages and interest remain taxable. How New Jersey wrongful death claims work.

Workers' compensation

Workers' compensation benefits paid under a workers' compensation act for an occupational injury or sickness are excluded from income under 26 U.S.C. § 104(a)(1). Social Security disability benefits can interact with comp benefits in ways that affect taxes. More on workers' comp settlements.

Why settlement wording matters

The IRS looks at the reason the money was paid. A clear settlement agreement that describes the payment as compensation for personal physical injuries supports the exclusion. When a case involves both physical injuries and other claims, the agreement should allocate the money reasonably. This is a detail a careful lawyer handles before the release is signed.

Structured settlements

Instead of one lump sum, some settlements pay out over time through an annuity. When properly structured, the periodic payments for physical injuries are generally tax-free as well, including the growth built into them. That can be valuable for catastrophic injuries or minors.

What about liens?

Liens aren't a tax issue, but they do affect what you take home. Health insurers, Medicare, and Medicaid may have the right to be repaid from your recovery. See how liens work.

Frequently asked questions

Will I get a 1099 for my settlement?

Usually not for the non-taxable physical injury portion. Taxable parts, such as interest or punitive damages, may be reported.

Do I report a tax-free settlement on my return?

Generally, excluded physical injury damages don't need to be reported as income. Because every situation is different, check with a tax professional, especially if your case involved punitive damages, interest, or deducted medical expenses.

Does the lawyer's fee change the tax result?

For a fully excluded physical injury settlement, the fee generally doesn't create a tax issue. Where part of the recovery is taxable, attorney's fees can have tax consequences, so get tax advice.

This article is general information. For advice about your own taxes, consult a CPA or tax attorney.