What Type of Legal Settlements Are Not Taxable?

When it comes to what type of legal settlements are not taxable, the answer lies in the purpose of the compensation. Settlements meant to cover physical injuries or illnesses are generally not taxable under federal and Missouri laws. For example, payments for medical bills, lost wages due to physical injuries, or emotional distress directly tied to those injuries are excluded from taxable income. However, not all settlement components are tax-free. Damages such as punitive awards, interest on the settlement, or compensation for emotional distress unrelated to physical injuries are considered taxable by the IRS. Our Kansas City injury lawyers are committed to helping Missouri clients navigate these complex distinctions and protect their financial recovery.

In this blog, we’ll break down the differences between taxable and non-taxable settlements, explain what you need to know when filing taxes, and provide insights to help you maximize the tax-free portions of your compensation. 

How Much Tax Do You Pay on Personal Injury Lawsuit Settlements?

If your lawsuit agreement compensates you for physical injuries or illnesses, you typically won’t owe any taxes on that portion of the settlement. This is because, under IRS rules, compensatory damages intended to restore you to your original state (such as covering medical costs or lost income due to physical harm) are not considered taxable income. The key here is that the compensation must directly relate to the injury itself.

For instance:

• Medical expenses: Settlements for surgeries, hospital bills, ongoing therapy, or medication resulting from a physical injury are excluded from taxation. This also applies to future healtcare treatments if the injury has long-term consequences.
• Lost wages due to physical injury: If your lesion caused you to take time off work, the portion of the settlement reimbursing those lost wages is also tax-free. This ensures you are compensated fairly for time away from your job without additional financial burdens.
• Pain and suffering related to physical injuries: If you’ve experienced pain, discomfort, or long-term physical limitations from an accident, the compensation for those losses is usually exempt from taxes as well.

However, not every part of a settlement is free from taxation. Some components, such as punitive damages or interest earned on the settlement, are treated as taxable income.

For example:

• Punitive damages are designed to penalize the wrongdoer and are always taxable, regardless of the type of case.
• Interest on settlement amounts: If your settlement was delayed and includes accrued interest, the IRS considers this taxable income.

This distinction between taxable and non-taxable damages can make a significant difference when filing your taxes. It’s essential to have a thorough understanding of how your settlement is categorized to guarantee compliance with both federal and Missouri tax laws.

Nontaxable Lawsuit Settlements

Here’s how the nontaxable settlement section could include additional explanations and examples:

To determine what type of legal settlements are not taxable, you must focus on how the damages are categorized in your settlement agreement, as they are designed to compensate you for losses directly related to physical injuries or illnesses that are explicitly excluded from taxation under IRS rules. But, structuring your claim correctly is fundamental to certifying that these components are recognized as non-taxable.

Below is a detailed breakdown of common nontaxable components:

• Physical injury or illness compensation:
  Damages awarded for injuries sustained in an incident, such as a car crash, are almost always non-taxable. This includes payments for surgeries, rehabilitation, or physical therapy needed to recover from the injury. Additionally, damages for long-term physical limitations or disabilities caused by the accident are also tax-free, helping victims focus on their recovery without financial strain.
• Medical expense reimbursements:
  Settlements that reimburse you for medical expenses already incurred are non-taxable, provided you did not previously claim these expenses as deductions on your tax return. For example, if your settlement covers out-of-pocket expenses for hospital visits or prescriptions, these amounts won’t be taxed.
• Pain and suffering related to physical injuries:
  Pain and suffering damages tied to physical harm are excluded from taxable income. For instance, compensation for chronic pain caused by a severe accident would fall under this category.
• Loss of consortium damages:
  In some cases, damages awarded to compensate for loss of consortium (e.g., the loss of companionship due to a spouse’s injury) may also be tax-free, provided the damages relate to a physical injury claim.

Each of these categories represents a tax-free portion of your settlement. Working with a qualified attorney verifies that your compensation is structured in a way that clearly separates non-taxable damages from taxable ones, protecting your financial recovery.

Taxable Lawsuit Settlements

While some legal agreements are exempt from taxes, other types of damages must be included as taxable income. The IRS classifies these taxable components based on their purpose, and failing to report them accurately can lead to penalties or audits.

Here are the most frequent taxable components of lawsuit settlements:

• Lost wages in non-physical injury claims:
  If it includes compensation for lost wages related to a claim not involving a physical injury, this portion is taxable. For example, in cases of employment discrimination or wrongful termination, the IRS treats lost wages as taxable income, just as if you had earned them during normal employment. This income will also be subject to federal and state income tax and payroll tax deductions.
• Punitive damages:
  They are awarded to punish the defendant for particularly egregious behavior. These damages are fully taxable, regardless of whether the underlying claim involved physical injury or not. For instance, if a court awards punitive damages in a Missouri car accident case where the driver was found grossly negligent, this amount must be included in your gross income and taxed accordingly.
• Emotional distress or mental anguish unrelated to physical injuries:
  If you are compensated for emotional distress or mental anguish not tied to a physical injury, this portion of the settlement is considered taxable. For example, a settlement for workplace harassment or defamation that resulted in emotional suffering would fall into this category. Nonetheless, if the emotional distress stems directly from a physical injury, it may be exempt from taxes.
• Interest on settlement amounts:
  Any interest accrued on a delayed settlement payment is considered taxable income. For example, if your settlement award includes interest earned while the case was pending, the IRS requires you to report this interest as income. 

By understanding these taxable components, you can work with your attorney to structure your settlement in a way that minimizes your tax liability. A clear breakdown of the taxable and non-taxable amounts in your settlement agreement will also simplify the process of filing your taxes.

What Do I Need to Know When Filing Taxes After My Settlement?

Filing taxes after receiving a legal settlement requires careful preparation to ensure compliance with both federal and Missouri tax laws. Different settlement components are treated differently for tax purposes, so knowing how to categorize and report them accurately is essential to avoid complications.

• Obtain a detailed breakdown of your settlement:
  A properly itemized agreement is crucial for distinguishing between non-taxable portions and taxable components. Compensation for medical expenses, physical injuries, or emotional distress tied to those injuries is generally tax-free. However, taxable components such as punitive damages, interest on delayed payments, or non-physical injury-related damages must be accurately identified. Without this breakdown, you could face errors when reporting income, potentially leading to fines or IRS scrutiny.
• Report taxable damages properly:
  Taxable portions of a settlement must be reported as part of your gross income. For instance, punitive damages awarded to punish a defendant or interest earned on a settlement amount are considered taxable under federal rules, as explained in IRS Publication 4345.
• Account for prior deductions:
  If you previously deducted medical expenses for which you later receive reimbursement as part of your settlement, those payments must be reported as taxable income. This prevents double-dipping, where a taxpayer benefits twice from the same deduction. For example, if you deducted $10,000 in medical expenses on a previous return and received a settlement covering those expenses, the IRS requires that amount to be added back to your taxable income.

Maintaining proper records, including legal documents and settlement agreements, is essential when filing taxes. Working with an experienced attorney or tax professional guarantees all taxable portions are handled correctly and prevent errors that could lead to penalties. With a properly structured settlement, you can minimize your tax burden while complying with all relevant laws.

Contact a Personal Injury Lawyer for Expert Guidance

Managing the tax implications of a legal settlement can be challenging, but the proper legal support can make all the difference. At Devkota Law Firm, we focus on protecting your settlement and verify you receive the full compensation you deserve. Our skilled attorneys are well-versed in the legal and tax intricacies of personal injury cases and are ready to provide the guidance you need.

Located at 4010 Washington Street, Suite 350, Kansas City, MO, we are here to help Missouri clients like you get the best possible outcome. Contact us today at (816) 207-4255 to schedule a consultation with a trusted Personal Injury Lawyer and let us help you secure the compensation you’re entitled to.