If the claim arises out of a physical injury to some part of your body, the entire settlement or verdict is non-taxable, even if it includes compensation for items like mental or emotional distress, medical bills, lost wages, and loss of future earning capacity.
Amounts recovered in some other kinds of lawsuits, like employment discrimination or wrongful termination, can be considered taxable income that must be reported to the IRS. But any settlement or verdict that is based on a physical injury is non-taxable.
There is one exception to this rule. If you took a medical expense deduction for any of the medical bills you incurred as result of the injury, then you have to report taxable income equal to the amount of the medical expense deduction you had previously taken. Click here for an IRS publication that covers this topic.
– Paul Johnson, Esq.