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Are Personal Injury Settlements Taxable? Keeping More of What You’re Owed

Founding Member of Moshes Law, P.C.
During his years of practice, Yuriy has concentrated in litigation and real estate transactions as his areas of expertise.

A personal injury settlement is money you receive when you’re hurt because of someone else’s negligence. This could be from a car accident, slip and fall, or other incidents. In the United States, on average, personal injury settlements can range from $5,000 to well over $100,000 depending on the severity of the injury.

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Since the money is compensating for your injury, it generally isn’t considered income you’d normally earn from a job. However, tax laws can be tricky, so people in New York might wonder if the settlement affects their taxes.

Compensatory damages for physical injuries, like medical bills, lost wages due to injury, and even pain and suffering caused by the physical injury, are generally not considered taxable income by either the IRS or New York State. That’s a significant chunk of your settlement potentially staying in your pocket! 

Here’s an example: Let’s say you break your leg in an accident and receive a settlement of $100,000. If the entire settlement is for medical expenses, lost wages due to recovery, and pain directly related to the broken leg, you wouldn’t owe any federal or state taxes on that money.

It’s important to note that there are exceptions:

  • Punitive damages, awarded to punish the responsible party for egregious behavior, are typically taxable.
  • Lost wages not directly related to a physical injury might be considered taxable income (like if you were fired for a discriminatory reason).
  • Interest earned on the settlement amount is also taxable.

When are Personal Injury Settlements Not Taxable?

A. Compensatory Damages for Physical Injuries

Generally, most of your personal injury settlement in New York City won’t be taxed by the federal government. That’s because the money is seen as compensation for your losses, not income. This applies to:

  • Compensatory damages: This covers awards for your actual losses, such as medical bills, lost wages, and pain & suffering.
  • Medical Expenses & Lost Wages: Let’s say your settlement reimburses you for $20,000 in medical bills and $10,000 in lost wages. This entire $30,000 is likely tax-free.
  • Pain & Suffering (due to physical injury): Compensation for the physical and emotional distress caused by your injury is also generally not taxed.
Here’s the key distinction:

  • Compensatory damages aim to make you whole again after an accident.
  • Punitive damages (not covered by this section) are meant to punish the person who caused your injury. Punitive damages awarded in NYC might be taxable.

The relevant tax code for this exclusion is IRS Section 104(a)(2). This section applies to compensation received for “personal physical injuries or physical sickness.”

It’s important to note:

  • This applies whether you receive a lump sum or periodic payments.
  • If you previously deducted medical expenses on your tax returns, the tax-free amount of your settlement for medical costs may be reduced.

B. Emotional Distress Tied to Physical Injury

In New York City, just like federal tax law, compensation you receive for emotional distress caused by a physical injury is generally not considered taxable income. This means you won’t owe taxes on that portion of your settlement or award.

Here’s the key:

  • Physical Injury First: The emotional distress must stem from a physical injury.
  • Documentation Matters: For the IRS to consider it non-taxable, there should be clear documentation that the emotional distress resulted from the physical injury. Medical records linking the two can be helpful.

Let’s say you were in a car accident and suffered a broken leg. As a result of the accident and your injuries, you developed Post-Traumatic Stress Disorder (PTSD). The compensation you receive for your PTSD would likely be considered non-taxable because it’s a direct result of your physical injuries.

It’s important to note:

  • This applies to emotional distress stemming from a physical injury. Compensation solely for emotional distress, without a physical injury, might be taxable.
  • If you previously deducted medical expenses related to the physical injury on your tax returns, any compensation received to reimburse those expenses might be taxable.

Exceptions to Non-Taxable Settlements

While most settlements in New York City aim to compensate you for losses, not all the money you receive is tax-free. Here are some key exceptions to be aware of:

A. Punitive Damages: Punishment, Not Payday:

Punitive damages are meant to punish the wrongdoer, not simply replace your losses. Let’s say you’re injured in a car accident due to reckless driving.  The settlement might include compensation for medical bills and lost wages, which are generally non-taxable. But if the settlement also awards punitive damages to punish the reckless driver, that portion could be taxed by the IRS. 

B. Interest on the Award:

While the main settlement amount might be non-taxable, any interest earned on that money while it’s held in an account could be subject to taxes. It’s a good idea to discuss this with your tax advisor to understand how interest might impact your tax bill.

C. Double-Dipping on Medical Expenses:

If you previously deducted medical expenses on your tax return, any portion of the settlement that reimburses those same expenses might be considered taxable income. This is to prevent people from essentially getting a tax break twice for the same medical costs.

Remember: This is just a general overview. Tax laws can be complex, and it’s always best to consult with a qualified tax professional for personalized advice on your specific situation.

Impact on Financial Planning: Personal Injury Settlements in NYC

Receiving a personal injury settlement in New York City can be a turning point, but it’s crucial to understand its impact on your financial plan. Here’s a breakdown of key considerations and strategies:

Considerations for Recipients:

  • Settlement Structure: NYC follows general personal injury law. Compensation typically covers medical expenses, lost wages, pain & suffering, and future care needs. Understanding how the settlement is allocated is vital for planning.
  • Long-term Needs: Injuries can have lasting effects. Factor in potential future medical needs, rehabilitation costs, and any impact on your earning potential.
  • Debt Management: Avoid using the settlement to pay off unsecured debts (credit cards, loans) aggressively. Prioritize essential debts and create a debt repayment strategy alongside your financial plan.
  • Lifestyle Changes: A windfall can be tempting, but resist major lifestyle changes immediately. Assess your long-term needs before altering your spending habits.

Strategies to Minimize Tax Liabilities:

  • Generally Non-Taxable: Thankfully, most personal injury settlements in NYC are exempt from federal and state income taxes. This applies to compensation for physical injuries, pain & suffering, and emotional distress.
  • Exceptions: Punitive damages or interest earned on the settlement may be taxable. Consult a tax advisor to understand the specifics of your case.
  • Medical Expenses: If a portion of the settlement reimburses documented medical expenses already paid, that amount may be taxable. Keep detailed records of medical bills.

Personal Injury Settlements and Recent Tax Law Changes

Here’s a breakdown of recent tax law changes that might affect your personal injury settlement in New York City:

Key Change: The Tax Cuts and Jobs Act of 2017 (TCJA) affects how some personal injury settlements are taxed.

What’s Not Taxed (Generally): Thankfully, compensation for physical injuries in NYC typically remains tax-free under federal law (Section 104(a)(2) of the Internal Revenue Code). This applies to damages for pain, suffering, lost wages due to injury, and medical expenses.

Statistics to Consider:

  • The National Center for State Courts reports that in 2021, an average personal injury jury award in the US was $131,000.
  • The IRS estimates that about 30% of personal injury settlements involve some element of emotional distress.

When To Hire A Personal Injury Lawyer

If your settlement includes various components, like medical expenses, lost wages, pain and suffering, and punitive damages, a lawyer can ensure each portion is categorized correctly for tax purposes. If you have any uncertainties about the tax treatment of your specific settlement, a lawyer can clarify and advise you on the best course of action.

For complex settlements or significant sums, a personal injury lawyer with tax expertise can provide valuable guidance. Consulting with a personal injury law attorney can provide peace of mind and ensure you’re reaping the full benefits of your settlement.

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