Picture this: After sustaining severe injuries in an accident, you’ve finally reached a settlement in your legal case and recovered substantial compensation. Suddenly, a scary thought occurs: Are personal injury settlements taxable in Indiana? You have significant financial and medical needs, and income taxes could take a big chunk out of your settlement. Knowing whether your settlement qualifies as taxable income is crucial, and planning accordingly is crucial.
Here’s the good news: In general, most of the money from a personal injury settlement is not taxable income. However, the details matter in these cases, and not paying taxes on some parts of your settlement could lead to legal penalties.
Does Indiana Tax Personal Injury Settlements?
In Indiana, there are two main kinds of taxes to worry about when dealing with a personal injury settlement. The first is Indiana’s state income tax. (The second is federal taxes, which we will cover later on.)
Broadly speaking, you don’t have to pay state income taxes on personal injury settlements in Indiana. The justification for this is that a personal injury settlement isn’t “income” in the traditional sense. Remember: A personal injury claim aims to compensate you for your losses due to someone else’s action. These losses could be money you’ve already spent or lost, such as your medical bills. You can also recover compensation for money you will lose in the future, such as your reduced future income.
Neither of these scenarios fits the standard definition of income according to state tax officials. Furthermore, most people recognize that it’s cruel to ask someone who’s sustained severe injuries to pay taxes on a settlement. Either way, you usually don’t have to worry about paying Indiana income taxes on your settlement.
One possible exception to this rule is compensation for your lost wages or other income. Sometimes, you might have to pay income tax on this part of your settlement, as it may qualify as taxable income. Ask a lawyer or tax professional for advice on this complex issue.
IRS Guidelines for Personal Injury Settlements
The IRS generally takes the same attitude toward personal injury settlements as Indiana tax authorities. That means you usually don’t owe federal income taxes on a personal injury settlement.
That said, the situation is a little more complicated regarding federal income taxes and personal injury settlements. Here’s what IRS guidelines say about taxes on personal injury settlements:
- Physical Injury or Sickness Settlements: If your settlement compensates you for physical injuries or illness, it’s generally non-taxable. However, if you previously deducted medical expenses related to your injury, you’ll need to report the portion of your settlement that covers those expenses. This rule helps ensure that you don’t receive a double tax benefit for the same costs.
- Emotional Distress and Mental Anguish: If your settlement includes compensation for emotional distress or mental anguish resulting from a physical injury or sickness, this portion is typically non-taxable. However, if the emotional distress isn’t tied to a physical injury, that part of your settlement is taxable. You can reduce the taxable amount by deducting medical expenses related to emotional distress, as long as those expenses weren’t previously deducted or provided a tax benefit.
- Interest on Settlements: Any interest earned on a settlement is always taxable and should be reported as interest income. This applies to any interest accrued before you received the settlement, ensuring transparency in income reporting.
What About Punitive Damages?
You can’t get punitive damages in a settlement. Those can only be awarded by a court. However, punitive damages in a personal injury award are always taxable income. Why? Because, unlike your other compensation, punitive damages aren’t tied to your economic or non-economic losses. Instead, the purpose of punitive damages is to penalize defendants in cases involving extreme negligence or intentional wrongdoing.
There’s good and bad news regarding taxes on punitive damages. The good news is you likely don’t have to worry about these taxes, as punitive damages are hard to win in Indiana. The bad news is that the tax rate can be high if you did win punitive damages. Make sure you talk to your lawyer or tax advisor about potential taxes on any punitive damages you recover.
How To Minimize Taxes on Your Indiana Personal Injury Settlement
While you want to minimize your tax liability for a personal injury settlement, you also don’t want any trouble with the IRS or state tax officials. Here are some tips to help you reduce potential taxes on your settlement:
- Focus on Physical Injury Compensation: Since settlement payments for physical injuries or sickness are generally non-taxable, clarify that the majority of your settlement is for physical harm. A clear allocation to physical injuries can help reduce the taxable portions of your settlement.
- Separate Emotional Distress from Physical Injury: If your claim includes emotional distress, ensure it’s tied to a physical injury. Emotional distress linked to a physical injury is usually non-taxable, while distress without a physical component typically qualifies as taxable income.
- Avoid Taxable Interest: Interest you earn on a settlement is taxable. Try to structure the settlement so payments don’t accrue interest. This can prevent the IRS from taxing portions of your settlement as interest income.
- Seek Specific Language in the Settlement Agreement: Work with your attorney to include specific language that clearly allocates compensation to non-taxable categories. An organized, detailed agreement can support your claim if the IRS questions it.
- Deduct Medical Expenses Carefully: If you deducted medical expenses related to your injury in prior years, consult a tax professional about how this may impact your settlement. Avoid double deductions by understanding how previously claimed medical costs affect the taxability of your settlement.
- Consult a Tax Professional: Each case is unique, and tax laws can be complex. Working with a tax professional helps ensure you understand all your options and make the best financial choices for your settlement.
Contact Our Indianapolis Personal Injury Attorneys Now
Hankey Marks & Crider understands the financial pressures you face after an accident. Our Indianapolis personal injury lawyers can help you minimize your tax liability and keep more of your settlement. Call our law firm through (317) 634-8565 now for a free consultation, or you can complete our contact form.