Many people are surprised to learn that taxes can play a part in a personal injury settlement. After months of dealing with medical expenses, missed work, and insurance company delays, the last thing anyone wants is an unexpected tax bill. Clients ask us at Recovery Law Center if their settlement will be taxed, and the honest answer is that it depends on how each part of the settlement is classified under federal law.
As a Hawaii personal injury lawyer, Glenn Honda has guided injured people through this exact concern for decades. We take the time to explain how the IRS treats physical injury compensation, lost income, emotional distress, punitive damages, and attorney fees so you can understand what stays tax-free and what may be considered taxable income. Our goal is to give you clear, practical information before you accept a settlement check or sign a settlement agreement, because a well-structured settlement protects more of what you worked hard to recover.
If you’ve been hurt and need assistance from a knowledgeable injury lawyer in Honolulu, contact us today to learn more in a free consultation.
How Hawaii and Federal Law Treat Personal Injury Settlements
For most personal injury cases in Hawaii, the vast majority of compensatory damages are not taxable. Federal tax law controls this area. The IRS considers settlement funds paid for personal physical injuries or physical sickness as non-taxable. This applies to amounts that include compensation for pain and suffering, medical costs, and other damages directly tied to the injury.
This rule covers injuries from car accidents, slip and fall claims, medical malpractice, and similar personal injuries. As long as your settlement proceeds relate to a physical injury, the IRS does not view these amounts as taxable income. Hawaii follows federal law in this area, so state law does not add extra tax burdens.
Can My Injury Settlement Be Taxed in Hawaii?
If you are considering an injury settlement offer or suing for compensation in Hawaii courts, you may be wondering whether the monetary award you could receive will be subject to state or federal taxes. In short, the answer depends on the nature of your accident, the losses and injuries you suffered, and the payment you ultimately accept.
Below, the legal team at the Recovery Law Center addresses some of the most common concerns and frequently asked questions our clients have about personal injury settlements and taxable income here in Hawaii.
What if I Received My Compensation from the Proceeds of a Trial Verdict?
According to Section 104 of the United States tax code, the compensation that injured victims receive from a personal injury claim is not subject to either state or federal income tax. It does not matter whether you receive compensation from a settlement agreement that is finalized before or after you file a lawsuit, or if your compensation comes from the proceeds of a trial verdict.
Neither the IRS nor the state of Hawaii can levy taxes on any financial awards you receive to compensate you for a physical injury or illness. The compensation you are awarded for your physical injury can also be excluded from your gross income when you file your annual tax return.
What If I Receive a Lump-Sum Payment For My Personal Injury Claim?
In the United States, individuals with higher incomes may be subject to unique taxation requirements under the alternative minimum tax (AMT). If your annual income exceeds the exemption threshold for the AMT, you may need to calculate your taxable income using AMT rules rather than the standard tax system, which could mean that you’d owe more in taxes.
AMT rules are much stricter than regular tax rules and do not allow for itemized deductions. This means that if you receive a single lump-sum payment for your personal injury settlement, you may not be able to separate the tax-exempt income you receive for things like physical injuries from the taxable income you receive for other losses.
Because of this distinction, many personal injury claimants choose to accept taxable compensation payments over several years through a structured settlement. This allows you to report less taxable income in any given year and avoid the AMT’s implications. A personal injury attorney can help you work out a settlement agreement that considers these factors.
What If I Invest the Money I Receive From My Settlement?
If you decide to invest any money you receive from your settlement, you should also be aware of the possible effects of the net investment income tax (NIT). You may be subject to NIT requirements if you earn a substantial amount of investment income and your adjusted gross income exceeds certain thresholds.
Even if you only make investments using non-taxable proceeds from your settlement, the money you earn from those investments is often taxable. However, it may be possible to avoid paying taxes on such proceeds if you agree to receive them over a more extended period in a structured settlement.
How Can I Structure My Settlement Agreement to Reduce My Tax Burden?
The way that your settlement proceeds are taxed could depend on the intent of the party that paid you and the language of your settlement agreement. For example, if your settlement agreement does not explicitly refer to the fact that you are receiving compensation for a physical injury, the IRS may not be able to verify that the money should be tax-exempt.
To avoid unnecessary tax burdens, you should work with your attorney to ensure that your settlement agreement explicitly includes:
- The payor’s reason for paying you the settlement
- Which portions of the settlement payment are taxable or non-taxable
- A provision that prohibits the payor from issuing you a 1099-MISC form for income that should be non-taxable
What Can and Cannot Be Taxed After a Settlement?
In many cases, injury settlements include compensation for both physical injuries and non-physical effects suffered by accident victims, such as emotional distress or mental anguish. It’s important to consider how the types of compensation you are awarded could affect your overall tax burden since different types of compensation are taxed in different ways.
The law specifies that most settlement or verdict proceeds you receive from a personal injury claim are exempt from state or federal income tax. This is because most personal injury claims include compensation for physical injuries, which are non-taxable under the IRS. Any money you receive as direct compensation for the effects of a physical injury or illness will not be considered taxable income or included in your gross income for tax purposes. This includes compensation for things like medical expenses, lost wages, and attorneys’ fees.
However, if you receive payment for non-physical damages like emotional distress, psychological therapy expenses, or loss of quality of life, those kinds of compensation could be considered taxable if they were not directly related to your personal injuries. You would only be able to avoid paying taxes on compensation for non-physical issues if you structured your settlement agreement to specify that your emotional distress or other non-physical issue was a direct result of your physical injuries.
Finally, if you were injured in an accident in which the at-fault party was especially negligent, reckless, or intentionally malicious, you could be eligible to receive punitive damages. Compensation for punitive damages is awarded to punish defendants in cases of egregious negligence, and such payments are always taxable. The best way to ensure you do not pay unnecessary taxes on payments you receive for punitive damages is to have your award separated into compensatory and punitive damages, so the IRS knows which portions of your income are non-taxable.
Do I Need to Report My Settlement to the IRS?
If the payment you received from your personal injury settlement was intended solely to compensate you for the effects of your physical injuries, the proceeds should not be considered taxable, and you should not have to report them to the IRS. However, if you received any punitive damage payments or compensation for non-physical injuries unrelated to physical injuries, those settlement proceeds could be considered taxable, and you may need to include them when you file your tax return.
Any taxable settlement payment you receive will be taxed according to your ordinary income tax rates, but larger payments or lump-sum settlements could push you into a higher tax bracket. No matter what kind of settlement you consider or accept, it’s a good idea to consult with a knowledgeable attorney to make sure you understand the full tax implications of the agreement.
Contact a Personal Injury Lawyer in Honolulu If You’ve Been Injured
Tax rules can leave people unsure about the best way to handle a settlement, especially when a case involves several types of damages or long-term medical care. Each person’s situation is different. For more than 25 years, founding attorney Glenn Honda and his relentless team have worked hard to make life easier for our clients. As one of our clients, Al Notarfrancesco, shared:
Recovery Law Center are dedicated, compassionate, and consistently advocate for their clients with integrity. It’s clear they genuinely care about the people they represent. I highly recommend them to anyone seeking personal injury representation in Hawaii.
If you have questions about taxation, settlement funds, or how to protect your compensation, we offer a free consultation to review your personal injury claim.
