Tamara E. Holmes
No one wants to be hurt in an automobile accident. But if you find yourself in that position and win a settlement as a result, you may not be penalized when tax time rolls around – depending on what kind of damages you seek.
Financial judgments that compensate you for physical injuries suffered in an accident aren’t considered income by the IRS. As a result, a settlement that covers a trip to the ER and follow-up visits to a doctor for treatment of an accident injury doesn’t have to be reported on your tax return. Not only do medical bills fall into this category, but emotional pain resulting from a physical injury would be included as well.
There is an exception to this rule. If you’ve deducted your medical expenses on your tax return in a year before receiving the settlement, the part of the settlement that reimburses those medical expenses would be taxable, says Mark Goldschmitt, a CPA who’s a manager at Mayer Meinberg, an accounting firm in New York. For example, if you received a settlement of $60,000 for medical expenses and deducted $30,000 on a previous tax return, you’d have to pay taxes on only the $30,000 you previously reported, Goldschmitt says.
The tax man’s due
However, the IRS is not as generous if physical injuries are not involved. Say you’ve experienced nightmares since the accident and you sue someone for causing mental anguish. You might win the case, but you’ll have to pay taxes on the money you receive.
You’ll also have to pay taxes if you’re awarded money for lost wages. “Money for lost wages is taxable income, just as the wages would have been had you received them,” says Bruce Givner, a tax attorney and managing partner at California law firm Givner & Kaye.
Sometimes, a judge will award punitive damages to punish the defendant and send a message to the community that similar actions won’t be tolerated. For example, if a drunk driver causes an accident, punitive damages may be awarded. While such damages can be generous, they are taxable. You’ll need to report them on your tax return and pay taxes on them.
In some cases, settlements are awarded in installments, with interest added to the payments. If that happens, the settlement itself may not be taxable if it covers medical expenses, but you’d have to pay taxes on the interest earned.
Finally, it’s important to note that while you may have racked up legal fees to win your settlement, the money you spent is generally not deductible, so you’ll simply have to take the loss.
Paying the taxman
If you know you’ll be receiving a settlement, don’t wait until April of the following year to consider the tax implications. Instead, contact a tax attorney or a CPA to talk about how the settlement will affect your taxes, says Andrew Schrage, owner of MoneyCrashers.com, a personal finance website. You may find that you’ll need to pay taxes on the settlement before the April 15 due date. If the settlement results in a tax bill of at least $1,000, you may be penalized if you don’t make estimated payments – advance payments that the IRS requires for income that’s not subject to withholding.
Despite the fact that the tax implications of a settlement can make a difference in how much money you keep, you never should let them affect the financial damages you’re seeking in a personal injury case, says William Seegmiller, a personal injury attorney in California. The determining factor always should be the pain and suffering caused by the accident, Seegmiller says.