One of the most common questions we hear from our clients is:  

Can my settlement be taxed?

Short answer: Yes, but there are contingencies. Money that is awarded to compensate you for a physical injury or physical sickness is generally tax-free. But some parts of a settlement, like punitive damages and interest, are taxable.

Why Is Some Money Tax-Free?

Under Internal Revenue Code §104(a)(2), compensatory damages received “on account of” personal physical injuries or physical sickness are excluded from gross income. In plain English: money meant to make you whole for a bodily injury or illness is usually not taxed.

Remember, the “Physical” matters. If your claim is not for a physical injury (for example, emotional distress without bodily harm, defamation, discrimination, or breach of contract), the IRS typically treats it as taxable unless an exception applies.

What’s Usually Tax-Free?

If your settlement or verdict stems from a physical injury or physical illness, these components are generally excluded from income:

1. Medical Expenses (Past & Future) – Reimbursement for ER visits, surgeries, therapy, prescriptions, medical devices, etc.
2. Pain and Suffering (Physical) – Non-economic damages tied to physical harm—pain, loss of enjoyment of life, scarring—are typically excluded.
3. Lost Wages or Loss of Earning Capacity (From Physical Injury) – If you missed work because of your physical injury, the wage component is generally excluded even though wages are usually taxable in normal circumstances.
4. Wrongful Death Compensatory Damages – Amounts paid to compensate for losses resulting from death are generally excluded (punitive damages related to wrongful death, however, are usually taxable).
5. Property Damage – If your property was damaged, such as what happens as the result of a car accident.
6. Attorney’s Fees on Excluded Damages – With contingent fees, the IRS often views you as receiving the gross recovery (including the fee) and paying your lawyer from it. If the underlying damages are excluded, the portion allocable to those excluded damages typically remains excluded.

What’s Usually Taxable?

These components often are taxed, even if part of your case involves a physical injury:

1. Punitive Damages – Because this is designed to punish the defendant, this type of compensation is routinely taxable.
2. Interest (Pre- or Post-Judgment) – Interest the settlement accrues while the case is pending or after judgment is taxable interest income.
3. Emotional Distress Not Attributable to Physical Injury – If your claim is for emotional distress alone, such as anxiety, sleeplessness, without a physical injury, those damages are generally taxable.
4. Lost Wages from Non-Physical Claims – For example, wage components in employment discrimination or wrongful termination cases (without physical injury) are taxable and may be subject to withholding and payroll taxes.
5. Medical Expenses You Previously Deducted – If you took an itemized deduction for medical bills in a prior year and later get reimbursed, you generally need to include that reimbursed portion in income.
6. Confidentiality/Non-Disparagement Payments – If a portion of a settlement is specifically allocated to a confidentiality clause or similar non-injury covenant, the IRS usually treats that portion as taxable ordinary income.
7. Sale of Structured Settlement Payments – If you later sell your structured settlement payments to a factoring company, that transaction can have tax consequences different from the original exclusion.

Key Takeaways

Bottom line: most money meant to make you whole for a physical injury or physical sickness is excluded from income under IRC §104(a)(2). The parts that aren’t compensatory—like punitive damages, pre/post-judgment interest, and payments tied to non-injury claims (e.g., pure emotional distress or confidentiality)—are generally taxable.

Smart Next Steps

Before you sign, have your lawyer and a tax professional review the draft settlement to get the allocations right. Your CPA can clarify tax treatment in writing and accurately submit compensatory tax details surrounding your settlement.