When pursuing a personal injury lawsuit in Colorado, accident victims are naturally concerned about whether any compensation they receive from a settlement or jury award will be taxable. If you are asking the question, “Do I have to pay taxes on a personal injury settlement?”, then it is prudent to consult a knowledgeable personal injury lawyer in Colorado Springs to discuss your best legal options.
Compensation for Medical Expenses and Pain and Suffering is Not Taxable
In general, settlements or jury awards from personal injury lawsuits are not taxable at the federal or state level in Colorado as long as the compensation is awarded for physical injuries or sickness. This is governed by Section 104(a)(2) of the U.S. Internal Revenue Code (IRC). The key factor in determining the taxability of personal injury settlements is what the compensation is used for.
- Physical Injuries: If the damages you receive are meant to compensate for physical injuries (e.g., broken bones, spinal cord injuries, traumatic brain injuries) or physical illness, the IRS does not consider this compensation taxable income.
- Emotional Distress Linked to Physical Injury: If emotional distress or mental anguish is directly related to a physical injury, then compensation for that distress is also generally non-taxable.
In other words, the non-taxable components of a personal injury settlement in Colorado may typically include:
- Medical expenses, such as hospital bills and doctor visits
- Costs for surgeries, physical therapy, and rehabilitation
- Future medical care
- Pain and suffering
- Emotional distress and PTSD
- Loss of consortium
- Costs of home modifications
- Costs for replacement services
- Property damage
A major portion of most personal injury settlements in Colorado generally includes medical expenses and compensation for pain and suffering, which will not be subject to federal or state income tax.
What Portions of a Personal Injury Settlement Are Taxable in Colorado?
Although most of the compensation in personal injury settlements is not taxable, there are certain components of the settlement that may be subject to taxes:
Lost Wages
If part of your settlement includes compensation for current and future lost wages due to time missed from work because of your injuries, this portion is generally considered taxable income. The IRS views lost wages similarly to regular income that you would have earned had you not been injured.
In Colorado, this means that compensation for lost wages and loss of future earning capacity is subject to both federal and state income taxes, just like your regular paycheck would be.
Interest on the Settlement
In some cases, a court may award pre- or post-judgment interest as part of a personal injury settlement. Pre-judgment interest is awarded to compensate you for the time between when the injury occurred and when you receive the settlement or award. Post-judgment interest accrues after a judgment is entered but before you receive payment.
Both pre-judgment and post-judgment interest are considered taxable income under federal law. If your case involves interest on the settlement, you will be required to report and pay personal injury compensation tax on the interest portion.
Punitive Damages
In rare cases, punitive damages may be awarded in addition to compensatory damages. Punitive damages are intended to punish the defendant for particularly egregious or reckless behavior and are always taxable under federal law. The IRS considers punitive damages to be a form of income so you will need to report them on your tax return and pay the applicable federal and state taxes.
Emotional Distress Not Related to Physical Injury
If you receive compensation for emotional distress or mental anguish that is not linked to a physical injury or sickness, this portion of the settlement is generally taxable. For instance, if your lawsuit involves a claim for emotional distress related to a wrongful termination or defamation, the compensation you receive for mental anguish would be considered taxable income.
However, if the emotional distress is a result of physical injuries, such as PTSD following a car accident, then the compensation for that distress is non-taxable.
Attorney’s Fees
The tax treatment of attorney’s fees in personal injury cases can be complex. In some instances, the IRS may require you to report the full settlement amount as taxable income, even if a portion of that amount goes directly to your attorney as their fee.
For example, if you receive a $500,000 settlement and your attorney’s fee is 30%, you may still be required to report the full $500,000 on your taxes, even though $150,000 goes to your lawyer. However, most personal injury settlements that compensate for physical injuries, illness, or pain and suffering are not taxable, so attorney’s fees in these cases would not create additional tax obligations.
Important Considerations for Colorado Personal Injury Settlements
While Colorado generally follows federal tax law, there are a few important considerations specific to the state:
- State Income Taxes: Colorado has a flat state income tax rate of 4.25% as of 2024. If any portion of your personal injury settlement is considered taxable (e.g., lost wages, interest, or punitive damages), it will be subject to this state income tax rate in addition to federal taxes.
- Structured Settlements: Some personal injury settlements are paid out over time through a structured settlement, rather than as a lump sum. Structured settlements are typically non-taxable, provided the underlying settlement compensation is for physical injuries. However, any interest or growth from the structured payments may be taxable.
Steps You Should Take to Protect Your Settlement
You should work with an experienced Colorado personal injury attorney and a tax professional to ensure that your settlement is structured in the most tax-efficient way possible. Here are some steps you can take to protect your settlement:
- Keep Accurate Records: Make sure to retain all documents related to your settlement, including the breakdown of how the compensation is allocated. This will help you and your tax advisor determine which portions of the settlement are taxable.
- Discuss with Your Attorney: Work with your attorney to negotiate the terms of your settlement carefully. For instance, it may be possible to allocate more of the settlement toward non-taxable damages (such as medical expenses and pain and suffering) and less toward taxable damages (like lost wages).
- Consult a Tax Professional: A tax advisor or CPA can help you understand the tax consequences of your settlement and ensure that you comply with federal and state tax laws.
FAQs on Personal Injury Lawsuit Settlement Taxation
Do I need to report a non-taxable settlement on my tax return?
In most cases, you do not need to report non-taxable settlement amounts related to personal injury claims on your tax return. However, if your settlement includes any taxable components, like punitive damages or interest, those portions must be reported.
Is compensation for medical expenses taxable if I deducted those expenses on a previous tax return?
If you previously claimed a deduction for medical expenses that were later reimbursed through a personal injury settlement, the IRS requires you to report the reimbursed amount as taxable income. This is known as the “tax benefit rule,” which prevents double-dipping on tax deductions.
Is compensation for lost future earnings taxable in a personal injury settlement?
Yes, compensation for lost future earnings is generally taxable. Since this portion of the settlement compensates for income that would have been subject to taxes, it is considered taxable income by both federal and Colorado state tax authorities.
How does the IRS handle settlements involving taxable and non-taxable damages?
When a settlement includes taxable (such as lost wages and punitive damages) and non-taxable (such as medical expenses and pain and suffering) components, the IRS requires that the settlement be properly allocated between these categories. Failing to do so could result in the entire settlement being taxed. It’s essential to ensure proper categorization when structuring the settlement to avoid unnecessary tax liabilities.
What are the tax implications if I took out a personal injury lawsuit loan?
The tax implications of taking out a personal injury pre-settlement loan on interest primarily depend on how your settlement is structured. The loan is not considered taxable income, so the amount you receive from the loan is not subject to taxes. However, the interest you pay on the loan is generally not tax-deductible. This is because the IRS does not allow the deduction of interest paid on loans used to cover personal expenses, including lawsuit funding.
Our Proven Colorado Personal Injury Lawyers Will Fight to Maximize Your Settlement
At Ganderton Law LLC, we pride ourselves on putting the “personal” back into personal injury law. Led by David Ganderton, a former insurance defense attorney with over 17 years of experience, we bring a unique perspective to every case, having worked both sides of the legal fence. David has successfully litigated multi-million dollar cases and recovered large settlements for injured victims. Named the Best of the Springs by The Gazette in 2024, our firm has the skills, experience, and resources to provide you with the strongest legal representation you need. If you have been injured due to someone else’s negligence, our Colorado personal injury attorneys will leave no stone unturned to prove liability and fight for the highest possible settlement for your injuries and losses. To schedule your free consultation, call us at (888) 711-4006 or contact us online.
