Sometimes. Under federal law, money you receive in a settlement or judgment is taxable unless an exclusion applies. The main exclusion—Internal Revenue Code §104(a)(2)—lets you exclude from income damages you receive on account of personal physical injuries or physical sickness (but not punitive damages). Everything else is generally taxable.
Below are the most frequent categories, how they’re taxed, and where the IRS says so.
What’s usually tax-free
Compensatory damages for personal physical injuries or physical sickness.
If your claim is for a bodily injury (e.g., broken bones from a car crash) or for a physical illness caused by the defendant, the settlement amounts that compensate you for those harms are typically excluded from income. It doesn’t matter if you got a lump sum or structured periodic payments—the exclusion still applies (except for any punitive damages).
Medical expenses related to a physical injury/sickness.
Reimbursements for medical costs tied to a qualifying physical injury are excluded. However, if you previously deducted those medical expenses and received a tax benefit, you may have to “recapture” them—i.e., include that portion in income. IRS Publication 525 covers these coordination rules.
What’s usually taxable
Emotional distress (without physical injury).
Damages for emotional distress (e.g., anxiety, humiliation) are taxable unless they stem from a qualifying physical injury/illness. The regulations specifically say emotional distress isn’t itself a physical injury. Amounts for medical care attributable to emotional distress may be excludable, but the distress damages themselves are income.
Punitive damages.
Always taxable, even when the underlying case involves a physical injury. Report as “Other income.” IRS Publication 4345 is explicit about this.
Interest.
Pre- or post-judgment interest is always taxable as interest income, separate from the principal settlement amount.
Wage-type recoveries (employment cases).
Amounts for back pay/front pay are treated like wages, are subject to withholding and employment taxes, and are typically reported on Form W-2. Other non-wage elements (e.g., emotional distress, punitive) are generally reported on Form 1099-MISC. The IRS summarizes these reporting and employment-tax consequences in its guidance on settlements and judgments.
Property damage beyond basis.
If a settlement for property damage exceeds your tax basis in the property, the excess is taxable (usually as gain); up to basis is a nontaxable return of capital. See Pub. 525 for basis and recovery concepts.
Confidentiality or non-disparagement payments.
Payments specifically allocated to a confidentiality covenant are typically taxable ordinary income (no §104 exclusion applies). See general IRS settlement tax guidance and Pub. 525 principles.
Attorney’s fees: who gets taxed on what?
For most taxable recoveries, the IRS treats you as receiving the gross settlement before fees, then paying your lawyer—meaning you may have taxable income including the portion paid to your attorney. The 2017 tax law suspended most miscellaneous itemized deductions, which often prevents offsetting those fees.
Important exceptions: Under IRC §62(a)(20) and (21), attorney’s fees and court costs are “above-the-line” deductions (i.e., they directly reduce gross income) for unlawful discrimination, certain civil-rights cases, and specified whistleblower awards. If your case fits these categories, you can usually avoid being taxed on the lawyer’s share. Check the statutory list and ensure your settlement agreement and reporting match.
Allocations matter (and so does documentation)
The origin of the claim and how your settlement agreement allocates the money (wages vs. physical injury vs. interest vs. punitive, etc.) strongly influence tax results. Courts and the IRS look at the facts and agreement language; careful drafting can help align the tax reporting with the substance of your case. IRS overview materials stress correct characterization and information reporting.
How settlements are reported
- Form W-2: employer-type wage elements (back pay/front pay).
- Form 1099-MISC: non-wage taxable amounts (e.g., emotional distress, punitive); sometimes 1099-NEC depending on circumstances.
- Form 1099-INT: interest.
IRS Publication 4345 explains these reporting norms and where to put items on Form 1040/Schedule 1.
Structured settlements
If the underlying damages qualify under §104(a)(2) (personal physical injury/sickness), structured settlement payments retain their tax-free character; investment earnings inside a qualified structure are not taxed to you. (If the claim isn’t §104-eligible, payments are taxable as received.) The §104 regulation confirms the exclusion framework.
State taxes & timing
Many states follow the federal rules, but state income tax treatment can differ—especially for employment claims and attorney-fee deductions. Also remember constructive receipt: money made available to you can be taxable in that year, even if you delay picking it up. The IRS explains these general principles and refers readers to Pub. 525 for details.
Practical tips
- Classify amounts in the settlement agreement. Break out wages, physical-injury compensatory damages, emotional distress, punitive, interest, and any confidentiality payments. Proper labeling helps align IRS forms and your tax return.
- Match the tax forms. Expect W-2 for wage pieces, 1099-MISC for most non-wage taxable items, and 1099-INT for interest.
- Claim fee deductions when eligible. If your case is an unlawful discrimination, certain civil-rights, or specified whistleblower matter, use the §62 above-the-line attorney-fee deduction.
- Keep medical evidence if you’re excluding amounts under §104(a)(2). The regs require the injury or sickness to be physical, and documentation helps.
Authoritative sources (latest editions)
- IRS Publication 4345, Settlements – Taxability (Rev. 9-2023). Clear rules on punitive damages, interest, and reporting.
- IRS Publication 525 (2024 edition), Taxable and Nontaxable Income. Current guidance on what’s income, basis recoveries, and coordination with other rules.
- Treasury Reg. §1.104-1(c) interpreting IRC §104(a)(2). Defines the physical-injury exclusion and the treatment of emotional distress.
- IRS “Tax implications of settlements and judgments” page (updated within the last year). Reporting mechanics and references.
- IRC §62(a)(20) & (21). Above-the-line attorney-fee deductions for discrimination and specified whistleblower awards.
Bottom line: If your settlement compensates for physical injuries/illness, it’s usually tax-free (except punitive and interest). Most other components—emotional distress, wages/back pay, punitive damages, and interest—are taxable. Nail down the allocations in your agreement, watch the forms you receive (W-2, 1099-MISC, 1099-INT), and claim any §62 fee deduction you’re entitled to. When in doubt, cross-check with Pub. 4345/Pub. 525 or consult a tax pro.
