The Taxman Cometh: Dealing With Taxes On Your Personal Injury Settlement

This year's tax deadline is just days away, and if you haven't already filed your taxes, chances are you're making a mad dash to get everything squared away. If you've recently received a personal injury settlement, then there's good news and bad news. The good news is that most of your settlement may be exempt from taxes. The bad news? Some portions may be subject to federal and state taxes.

Tax issues can get pretty complicated for the average person, so the following explains exactly how taxes affect your personal injury settlement. Depending on the type of settlement you received and how it's structured, you may not owe as much in taxes as you think.

What's Treated as Taxable Income?

The Internal Revenue Code may consider a significant portion or even all of your personal injury settlement as taxable income, depending on the circumstances. In many cases, the IRS may require you to report the following as income on your latest tax return:

• Damages awarded for physical injury or physical sickness in a personal injury claim based on a breach of contract
• Damages awarded for emotional distress that isn't directly related to your physical injury or sickness
• Damages awarded for non-physical injuries, including discrimination, harassment, and invasion of privacy.
• Punitive damages awarded as a part of your personal injury settlement, regardless of whether or not it's directly related to your physical injury or sickness
• Any interest accrued on your personal injury settlement throughout the course of your case

In addition to the above, you may also find your settlement proceeds subject to taxation if you took an itemized deduction for your medical expenses in previous years and received compensation for those expenses as part of your personal injury settlement. According to IRS guidelines, the tax benefit provided by your deductions must be reported as "other income" on your income tax form.

What's Considered Exempt?

While several aspects of your personal injury settlement may be taxed, others may be completely exempt. Parts of your settlement that are considered non-taxable usually include:

• Damages awarded for physical injury or physical sickness for any personal injury claim that does not involve a breach of contract
• Damages awarded for emotional distress that can be directly linked to your personal injury or physical sickness
• Damages awarded for emotional distress that eventually leads to physical sickness

Damages awarded for emotional distress were once considered non-taxable regardless of whether or not they were directly related to physical injury or sickness. However, a recent amendment to the Internal Revenue Code removed this exemption, making only emotional distress awards that are not directly related to physical injury non-taxable.

How Can You Reduce Your Liability?

If you're concerned about taxes eating away at your personal injury settlement, you may be able to reduce your tax liability with the help of a structured settlement. Instead of receiving your settlement in a lump-sum payment, you can designate some or all of your settlement proceeds to fund an annuity. In return, you'll receive annuity payments that are completely exempt from federal and state income taxes.

Not only does a structured settlement help reduce your tax liability by a significant amount, but it may also help you maintain your eligibility for certain government means tested programs, including Medicaid and Supplemental Security Income.

The only downside is that a structured settlement doesn't give you as much control over your settlement proceeds as a lump-sum payment. If you're afraid that your structured settlement payments won't keep up with inflation or other negative economic conditions, you may want to stick with a lump-sum settlement.

What About State Taxes?

Most states tend to follow the same rules and guidelines concerning personal injury settlements and taxation. However, not every state behaves the same way when it comes to your tax liability. If you're concerned about how state taxes may affect your personal injury settlement, you should talk to an accountant who is well-versed in the tax codes that govern your state.