Are Settlements Taxable As Income Under U.S. Law? (2025)

You were wronged in some way. You pursued a claim against the other party and succeeded in settling your dispute. One of the questions on your mind after receiving a settlement check is, “Are settlements taxable?”

Determining the taxability of a legal settlement requires you to look at the nature of the claim and the reason for the compensation. Settlements that arise from bodily injuries are exempt from federal income taxes. All other settlements, including those from non-physical injuries, may be subject to taxation.

Which Settlements Are Exempt From Taxation?

The IRS uses an expansive definition of “gross income” to cover all income from any source, including wages, profits, and property gains. This also includes lawsuit judgments and settlements. Thus, analyzing taxability starts with a presumption that the income is taxable unless a specific exemption exists.

However, federal tax laws exempt any compensation for injuries or sickness. The following types of exempt compensation are identified in the statute:

• Workers’ compensation for injury or illness
• Personal injury compensation for physical injury or sickness
• Benefits paid by non-employer accident insurance policies for injury or sickness
• Veterans’ benefits paid for physical injuries or illnesses
• Military disability benefits for injuries resulting from military or terrorist action
• State payments to family members of public safety officers killed in the line of duty

Thus, you may have a legitimate argument to exclude the following settlements from your gross income when you file your tax forms:

• Workers’ compensation settlement
• Personal injury settlement
• Wrongful death settlement
• Accident insurance settlement

Importantly, the IRS exempts all of your compensation from these sources, including compensation for lost income, medical expenses, and pain and suffering.

There are some important limitations on the exemption provided for these settlements. First, the settlement must be paid for a physical injury or sickness. Settlements for mental or emotional injuries do not receive the exemption unless there was an associated physical injury.

Thus, suppose that you suffered PTSD after a motorcycle accident. When riders have motorcycle accident injuries that include physical injuries, their compensation for PTSD may be tax-exempt. However, when riders suffer PTSD without any physical injuries, their motorcycle accident settlements may be taxed.

Second, only the portion of the settlement for compensatory damages may be tax-exempt. If you receive any punitive damages, the IRS may tax them.

When Are Settlements Taxable?

Conversely, all other lawsuit settlements are taxable. Specifically, any settlement for non-physical harm will be taxable. Thus, there will likely be a tax bill on the settlement check for every other type of case, including the following:

• Breach of contract lawsuits
• Employment claims
• Defamation of character lawsuits
• Property disputes

The difficulty arises when a dispute includes physical injuries as a component but the lawsuit was not a personal injury lawsuit. For example, a civil rights lawsuit against a police department might produce a tax-exempt settlement if the claim was based on excessive force. However, the settlement might be taxable if it was for a wrongful arrest without any physical injury.

Any part of a personal injury or workers’ compensation settlement that does not arise from your injury might also be taxable. For example, compensation for the following losses and costs are likely taxable:

• Prejudgment interest
• Punitive damages
• Attorney’s fees

You can also lose part of your tax exemption for settlements involving a physical injury by claiming the medical expenses exemption on your income taxes. In other words, you cannot take a tax exemption for your doctor’s bills and receive tax-free compensation for them. You must choose one or the other.

Also, there is a notable exception to the taxability of punitive damages. Awards for punitive damages are taxable unless they were awarded in a wrongful death lawsuit.

Determining Your Settlement Tax Rate

If your settlement is taxable, it will be added to your other income for that year. The same marginal tax rates apply to wages, interest income, and settlements. However, when you add the settlement to your other income, the settlement might get taxed at a higher rate.

In other words, marginal tax rates do not apply to your entire income. However, the portion of your settlement that exceeds the threshold for the higher rate could be taxed more heavily.

For example, suppose that you receive a settlement for lost wages due to employment discrimination. You will add your settlement to the wages you earned for that year. You will get taxed on the total amount. Your earned wages will only get taxed at the normal rate for that income. If your settlement pushes the total into a higher tax bracket, you will pay the higher rate on the portion of your settlement above the bracket’s threshold.

When you receive a taxable settlement, your litigation lawyer might recommend spreading out your settlement over time so you can reduce the risk that the checks will push you into a higher tax bracket.

How Do You Pay Taxes on Court Settlements?

After answering the question, “Are civil lawsuit settlements taxable?” you must determine how to report them.

If your settlement is taxable, you must include it as “other income” on your tax forms. When your settlement check comes from an insurance company, the company may even provide you with a tax form to document it. When you receive a tax-exempt settlement, you do not report it as income.

Learn More From ConsumerShield About Settlements and Taxation

Are settlements taxable? Unfortunately, the answer is not a simple yes or no. Instead, it depends on the nature of the claim and the reason for the settlement payments.

ConsumerShield provides people with educational resources so they can understand their legal situations, including their tax liabilities. We also connect people with lawyers to assist them. Contact us for a free case review and attorney referral.