Do You Have to Pay Taxes on a Personal Injury Settlement? 

You might have a few questions if you’ve recently received a damage award in Montana. Some people wonder, “Do you have to pay taxes on a personal injury settlement?”

This answer can help to make sure there are no surprises during tax season. The good news is that many personal injury settlements are not taxable, but there are exceptions that you need to know.

Here is a breakdown so you know what’s taxable, what isn’t, and how Montana’s laws apply to your situation.

Personal Injury Compensation Is Usually Tax-Free

The Internal Revenue Service (IRS) rules do have exceptions for personal injury settlements. If your settlement compensates you for a physical injury or illness, you usually don’t have to pay taxes on that amount. This may include a settlement for:

• Medical bills
• Pain and suffering
• Lost wages if they’re tied to the physical injury

For example, if you were in a car accident and received compensation for a broken leg, your settlement for medical expenses and the pain caused by the injury would not be taxable.

However, some parts of the settlement may be subjected to taxes.

What About Emotional Distress or Mental Anguish?

This is where it can become more complicated. If emotional distress or mental anguish comes from a physical injury, then the IRS will treat it the same way. That money is tax-free. But if it’s not directly related to a physical injury, the IRS considers it as taxable income.

For example, if you experienced emotional distress due to harassment at work and there was no physical injury involved, any compensation for that distress would be taxable.

Watch Out for Punitive Damages

Punitive damages are designed to punish the person for their egregious behavior that caused the harm to the plaintiff. According to the IRS, these damages are always taxable. Even if your case involved physical injuries, you will need to report any punitive damages you received as income.

Interest Payments Are Taxable

Sometimes, the case may take years to resolve, and your settlement accrued interest is considered taxable income. You will need to pay taxes on that portion. Interest is considered taxable income, whether from a physical injury, emotional anguish, or punitive damages.

What About Legal Fees?

Legal fees can complicate things. In most cases, if your settlement is tax-free, you cannot deduct your attorney’s fees. However, if part of your settlement is taxable, like punitive damages, you might be able to deduct the legal fees tied to that portion.

Structuring Your Settlement Matters

The way your settlement is structured will also impact your tax situation. If your agreement breaks down the settlement into compensatory damages for medical bills, pain and suffering, and lost wages, it is easier to prove that these portions are non-taxable.

However, if the agreement does not provide specifics, the IRS could decide to treat a larger portion as taxable income. In these cases, the burden falls on you to document which portion is non-taxable.

Can a Structured Settlement Reduce Taxes?

Instead of receiving your settlement as one lump sum, you might have the option of a structured settlement. With that, your payments are spread out over time. This can help you manage taxable income better by spreading it over multiple years. In turn, that can lower your tax burden.

What You’ll Need to Report to the IRS

If any portion of your settlement is taxable, you will usually receive a Form 1099-MISC from the payer. You will want to review it carefully and report any taxable amounts on both your federal tax returns.

How Montana Handles Taxes on Settlements

Income taxes are not just federally based. With the exception of a few, most states also collect state income taxes as well. How are these taxes handled on personal injury claims?

The state of Montana generally follows federal tax rules when it comes to personal injury settlements. This means that if the IRS does not tax a portion of your settlement, Montana will not either. However, any taxable parts, such as punitive damages or interest, will still need to be reported on your state income tax return.

You May Want to Work with an Attorney

Since personal injury settlements can involve a mix of taxable and non-taxable components, navigating the tax rules is tricky. Working with a personal injury lawyer who understands these cases can make all the difference. They will work to help you:

• Identify which portions of your settlement are taxable
• Ensure proper documentation and reporting
• Minimize your overall tax liability

If you’ve received a personal injury settlement in Montana, you will want to know which portions are taxable and why. Most settlements for physical injuries or illnesses are tax-free. However, some parts of the settlement, like punitive damages or interest, may be taxable and need to be reported.

At Western Justice Associates, PLLC, we are not just here to help get compensation for you but can provide advice about the steps afterwards, including possible tax implications.