A settlement can help make you whole again after an injury, but this money doesn't come for free. In most cases, a settlement is taxable, and the tax rate you'll pay varies depending on your income and the precise nature of the settlement. If you don't report your settlement earnings, you'll face the same consequences you'd face if you didn't pay taxes on your regular income, including fines, penalties and, in extreme cases, jail time.
Type of Settlement
Settlements come in all varieties. If the settlement is for money you are owed for employment or a service, it's taxable as regular income. For example, if you sue your employer for wage discrimination and are awarded back pay, you'll have to pay taxes on the money as if you earned it in your usual job. If the settlement is due to an injury -- including emotional distress -- it is generally not taxable. Although, punitive damages are always taxable.
Status of Injury
While money paid to help cover medical expenses after an injury is generally not taxable, there are exceptions. If you are awarded money for mental anguish or emotional distress but did not incur any actual medical expenses, you'll have to pay taxes. Taxpayers also have to pay taxes on any medical expenses that are less than 10 percent of their adjusted gross income. This means you could be stuck paying taxes for an injury if the sum you gain is small.
Role of Tax Deductions
Your tax deductions can affect how your settlement income is taxed. If you don't take an itemized deduction for medical expenses, your settlement winnings for a personal injury can't be taxed. If you do itemize your deductions, however, and the deductions for an injury occur over several years, the Internal Revenue Service requires you to list the money you paid each year.
Even though you won't have to pay taxes on some settlement winnings, you still have to report this income. In most cases, you'll need to report it on the "other income" line of your Form 1040. If the settlement is for back pay or other income you've earned, you'll have to report it as part of your wages on your tax return.
- Jupiterimages/liquidlibrary/Getty Images