From time to time, we are asked to advise clients on the tax impacts of personal-injury settlement income. Although every situation is different – and thus, each individual case requires special attention – there are some generalities which can be helpful to keep in mind. Internal Revenue Code (IRC) Section 104(a)(2) stipulates that “the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness” may be excluded from gross income, provided such amounts have not been previously deducted by the taxpayer under IRC Sec. 213 as medical expenses on a previous return*.
While the initial proceeds from a personal-injury settlement are generally tax-free, this tax-free status does not extend to investment income derived from the settlement proceeds. For example, a plaintiff may receive a lump-sum settlement of $500,000 and invest it in a variety of stocks and bonds. In this scenario, while the $500,000 initial payment may not be taxable, any dividends, interest, and capital gains generated would be considered taxable (barring tax-exempt investments such as municipal bonds, etc.). The same is true if the plaintiff were to invest settlement proceeds in annuities: a portion of the annuity payment represents a return of principal and would be tax-free, while the remainder would be taxable as ordinary income.
It should be noted that there is an exception to this general outline, however, which has been granted by Congress. This exception is referred to as a “structured settlement,” in which the plaintiff forgoes receipt of a lump-sum settlement in exchange for regular periodic payments from a defendant over a period of time, be it a fixed number of years, the remainder of the plaintiff’s life, etc. This periodic income stream – the “structured settlement” – is accomplished via an annuity purchased by the defendant, with the annuity payments going to the plaintiff. Unlike a plaintiff purchasing an annuity on his or her own with proceeds from a settlement (which would subject a portion of the income stream to taxation), Congress allows all proceeds from a structured settlement to be received tax-free. Thus, by taking advantage of a structured settlement, a plaintiff can obtain the benefits of an annuity (namely, a regular income stream for some period of time) without incurring taxation on any portion of the periodic payments. It should be noted that structured settlements are extremely rigid, not allowing for flexibility or changes to the payment terms once established, and for this and other reasons may not be right for all individuals. Nevertheless, knowledge about structured settlements can be beneficial as a plaintiff considers all of their options.
If you or a loved one happen to find yourself in a position to receive a personal-injury settlement, please don’t add issues concerning the taxation of your settlement to your already-full list of worries. We are here to help, so please contact us with any questions or concerns you may have.
* IRC Sec. 213 is the code section which allows a taxpayer to deduct medical expenses incurred when such expenses exceed 10% of the taxpayer’s adjusted gross income (this AGI floor is 7.5% for taxpayers 65 and over, through tax year 2016). Taxpayers who have deducted medical expenses which are later recovered as part of a personal-injury settlement should be aware that such recovery may be taxable under the “tax-benefit rule.” While beyond the scope of this article, our firm would be glad to explain the implications of such prior deductions; just give us a call and we can help.
This discussion is intended for educational purposes only, and may not be construed as actionable legal or tax advice without a thorough review of a taxpayer’s individual situation.