What Is Taxable in a Personal Injury Settlement Under the U.S. Tax Code?

The tax implications of a personal injury settlement or judgment can vary by jurisdiction. However, the federal tax code takes a fairly straightforward approach to these awards. If you're anticipating a personal injury award or settlement, you'll need to remember just a few key tax-related points about your potential windfall.

You're not required to pay taxes on any funds awarded to cover costs incurred as a result of the injury that you sustained. These costs can include medical bills and legal bills. Depending upon the amount by which your award exceeds the total cost of your injury, you may receive a substantial tax-free windfall as a result.

However, you must treat any punitive damages that you receive as taxable income. You'll add the full value of these damages to your "gross income" calculation on the tax return for the year in which the judgment was issued. In addition, you must report any award that you receive in compensation for lost wages as well.

While the tax issues surrounding personal injury awards are not overly complicated, the logistical arrangements involved in actually recovering the awarded funds can be daunting. Although your personal injury award technically makes you an unsecured creditor of the individual or entity against whom the judgment was issued, you may have to take some aggressive steps to ensure that you're paid.

In addition, most personal injury lawyers will take a "cut" of your award before you receive it. The at-fault party is obliged to deposit the funds into a trust account controlled by your lawyer or his or her law firm. Your lawyer will then transfer a portion of those funds from the trust account into his or her proprietary account.

This "cut" is traditionally one-third of the total value of the settlement. However, some "discount" lawyers may only take 20 to 30 percent of the funds. Others may charge upfront fees that reduce the total value of the back-end payment. In any case, your lawyer will transfer the remainder of these funds into your personal account or cut you a check for the balance.

Since this windfall may not be taxable, you should immediately place it into an interest-bearing account or use it to purchase stable investments that can magnify your earnings. If you have outstanding debts related to the incident for which the judgment was awarded, make sure to use the funds to settle them before making any unwise spending decisions.

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