How Personal Injury Settlements Are Taxed in Colorado
Request Free ConsultationWhen you receive compensation from a personal injury lawsuit, your first thought might be relief. You’re finally getting the money you need for your medical bills, time away from work, or lasting pain. But there’s one big question that often comes next: Will I have to pay taxes on this money?
Knowing how personal injury settlements are taxed in Colorado can help you avoid surprises and protect your financial future. While much of the compensation from an injury settlement isn’t considered taxable income, there are key exceptions.
The Internal Revenue Service (IRS) and the Colorado Department of Revenue both apply specific rules based on the type of damages awarded, how they are structured, and whether any deductions were taken in prior years. If you’re already dealing with physical pain and financial stress, the last thing you want is an unexpected tax bill. A knowledgeable personal injury lawyer in Denver, CO can help you understand how these tax rules apply to your specific case and guide you toward the best outcome.
Here we’ll look at the tax implications of personal injury settlements in Colorado and what you can expect, whether you’ve already received compensation or are still waiting on a resolution.
Key Takeaways for Colorado Personal Injury Settlement Taxes
- Not all personal injury settlement money is taxable; much of it is exempt under federal and Colorado law.
- Compensation for physical injuries, medical bills, and pain and suffering is generally not considered taxable income.
- Some portions of a settlement, like punitive damages or previously deducted medical expenses, may be taxable.
- The IRS and Colorado Department of Revenue follow specific rules about which damages count as income.
- Working with a Colorado personal injury lawyer can help protect the value of your settlement and avoid avoidable tax exposure.
Which Parts of a Settlement Are Taxable and Which Aren’t?
Not all compensation is treated the same by the IRS or the Colorado Department of Revenue. Personal injury settlements often combine several types of damages, and only some are considered taxable income.
Most of your settlement may be tax-free if it includes compensation for:
- Medical expenses related to treating a physical injury or illness
- Pain and suffering that result from a physical injury
- Physical injuries or sickness directly caused by someone else’s negligence
- Property damage, such as vehicle repairs
However, other components of your personal injury settlement can trigger tax liability.
The following compensation is usually taxable:
- Lost wages or lost income
- Punitive damages (intended to punish the defendant)
- Interest added to a judgment
- Reimbursement of previously deducted medical expenses
- Compensation for non-physical injuries, such as emotional distress unrelated to physical harm
When settlements include both taxable and non-taxable elements, they must be clearly itemized. Otherwise, the IRS may treat the full amount as taxable, and you could owe more than necessary.
Understanding IRS and Colorado Tax Guidelines
The IRS uses Section 104(a)(2) of the Internal Revenue Code to determine what is or isn’t considered income from a settlement. Under this rule, damages for “personal physical injuries or physical sickness” are excluded from gross income, as long as you didn’t previously take deductions for related medical expenses.
Colorado tax law for settlements generally mirrors the IRS’s approach. But small differences can exist, particularly in how interest or itemized deductions are handled at the state level.
For example, say you’re awarded $150,000 in a car accident settlement:
- $100,000 is for medical bills and pain and suffering
- $30,000 is for lost wages
- $20,000 is punitive damages
In that case, only the last two categories, totaling $50,000, would typically be taxable. But if your settlement doesn’t spell this out, the IRS might not separate them for you.
Is Emotional Distress Compensation Taxable?
This is one of the most misunderstood aspects of injury settlements. Many people assume emotional distress is always tax-free. It’s not.
The IRS only excludes emotional distress from taxable income if it stems directly from a physical injury or physical illness. If the distress came from a non-physical source, like reputational damage, discrimination, or workplace harassment, it’s generally considered taxable.
Even when emotional distress stems from a physical injury, proper documentation makes a difference. The IRS looks for consistency between what the settlement agreement states and what medical records show. Those records should clearly connect emotional symptoms, such as anxiety or depression, to the underlying physical injury. Statements from doctors or therapists can further support that link.
If that evidence is missing, the IRS may question whether those damages should be tax-free. A personal injury attorney can help ensure that emotional distress claims are properly documented and described in the settlement agreement to protect your compensation from unnecessary taxation.
The Tax Consequences of Previously Deducted Medical Expenses
Here’s a common situation that surprises many injury victims: If you deducted medical expenses on a previous year’s tax return, and your settlement reimburses those same expenses, you may owe taxes on that amount.
For example:
- You paid $10,000 in out-of-pocket medical costs in 2022
- You itemized those costs on your 2022 tax return
- You received a settlement in 2024 that reimburses you for those expenses
In this case, the IRS may require you to report the $10,000 as income in 2024. This is known as the “tax benefit rule,” which prevents you from getting a tax break on medical bills and also receiving tax-free reimbursement later.
If you didn’t deduct those expenses, you likely don’t owe tax on the reimbursement. But it’s worth confirming with a tax professional or attorney to avoid misreporting.
Do Taxes Apply to Lost Wages After a Settlement?
Compensation for lost income is usually taxed just like regular earnings. That includes:
- Missed paychecks due to time off work
- Lost self-employment income
- Missed bonuses or commissions
- Sick leave or PTO you couldn’t use
Even though these losses stem from an injury, the IRS considers them substitute wages and therefore taxable. You may even owe payroll taxes, like Social Security and Medicare (FICA), if the lost income is reported on a W-2 or 1099 form.
This can make a real difference in how much you keep from your settlement, especially if lost wages make up much of your total recovery.
Will You Receive a 1099 for Your Injury Settlement?
Sometimes yes, sometimes no. It depends on how the settlement is structured and what it includes.
You might receive a Form 1099-MISC if:
- Your settlement includes any taxable portion, like lost wages or punitive damages
- The settlement is paid by a business or insurance company
- Your attorney’s fees are reported separately on your behalf
Receiving a 1099 doesn’t necessarily mean your entire settlement is taxable, but it does mean the IRS has been notified of the payment. You’ll be expected to explain how the funds break down, especially if only part of it qualifies as income.
This is another area where having clear language in the settlement agreement can protect you. Without it, the IRS may assume more of the payment is taxable than is actually required by law.
Structured vs. Lump-Sum Settlements: Does It Affect Taxes?
The way your settlement is paid can influence how the IRS treats the money. While most personal injury victims receive a lump sum, some choose a structured settlement. Structured settlements spread payments over several years, often through an annuity. This option can provide long-term financial stability, especially for individuals with ongoing medical needs or limited work capacity.
Lump-sum payments arrive all at once and may make it harder to manage the money responsibly. They also pose a risk of triggering higher taxes if taxable portions are not clearly identified or allocated.
Each annual payment in a structured settlement must be evaluated to determine if any part is taxable. The structure itself does not change the nature of what is or is not taxable. What matters is how the original damages are categorized in the settlement agreement.
The IRS may treat structured settlements the same way it treats lump sums. However, lump sums often create more confusion when multiple types of damages are included and the agreement lacks clarity.
Legal Fees and Their Impact on Taxable Income
When you work with a personal injury lawyer, your compensation typically includes legal fees paid on a contingency basis. Most clients never write a check to their attorney. Instead, the lawyer receives a percentage of the final settlement. However, that does not mean the IRS ignores those fees when reviewing your tax return.
In some cases, the IRS considers the entire settlement amount to be taxable income, even if a portion of it went directly to your attorney. This usually occurs when the taxable portion includes lost wages, punitive damages, or emotional distress unrelated to physical injury. You may still be taxed on those amounts, regardless of how much went to your lawyer.
The IRS does allow some deductions for legal fees, but they are limited. After the Tax Cuts and Jobs Act, most individuals cannot deduct legal fees related to personal claims. There are exceptions, but they depend on the nature of the case. Injury-related compensation for physical harm remains tax-free, including the legal fees associated with it.
A personal injury attorney can help you structure your settlement to avoid unnecessary exposure to tax liability. The language in your agreement should clearly define what each portion of the settlement represents and how attorney fees are handled.
Minimizing Tax Exposure After a Settlement
Tax planning is not only for high earners or financial professionals. If you received a significant personal injury settlement, you should take steps to protect your funds and reduce any unnecessary tax risk.
Here are practical steps that can help:
- Work with a tax advisor before filing your next return
- Review how your settlement agreement allocates each type of compensation
- Track any medical deductions you previously claimed
- Request a clear breakdown of attorney fees
- Set aside funds to cover taxes if your compensation includes wages or interest
Preparation can prevent surprise tax bills and allow you to retain more of your settlement.
What Can Go Wrong Without the Right Advice?
Personal injury clients sometimes assume that all settlement money is theirs to keep. Unfortunately, that is not always true. Misunderstanding how settlements are taxed can lead to costly mistakes. The IRS does not offer flexibility once a return is filed. If a person fails to report taxable income, even by accident, they may owe penalties in addition to back taxes.
Failing to document the source of emotional distress damages can result in the IRS treating them as income. Receiving interest on a judgment without setting aside taxes can lead to shortfalls. Accepting a settlement with unclear language may result in a larger portion being taxed than necessary.
When victims do not seek legal or tax advice, they may leave money on the table or unintentionally put themselves at risk. An experienced attorney can prevent these outcomes by ensuring clarity, accuracy, and legal protection throughout the settlement process.
Frequently Asked Questions About Settlement Taxes in Colorado
Is all personal injury compensation tax-free?
No. Compensation for physical injuries and related medical bills is generally not taxed. However, certain categories, like lost income and punitive damages, are treated as taxable by both the IRS and the Colorado Department of Revenue.
Do I have to report my settlement on my taxes?
It depends on the contents of the settlement. If any portion includes taxable damages, such as wages or interest, you must report that amount. You are not required to report non-taxable damages, but you should still maintain documentation.
Can a lawyer help reduce my tax burden?
Yes. A lawyer can structure your settlement in a way that separates taxable and non-taxable damages. Clear language in the agreement can reduce confusion and support your case if the IRS challenges your return.
Will I receive a 1099 for my settlement?
You may receive a 1099 if any part of your compensation is considered taxable. This form usually comes from the insurance company or business issuing the payment. Receiving a 1099 does not mean the entire settlement is taxable.
Talk to a Lawyer Who Knows How to Protect the Value of Your Settlement
You did not ask to be injured. Now that you have fought to recover, you should be able to keep the compensation you were awarded. But when tax season comes around, the IRS may see things differently. Tax treatment can change the outcome of your case and your financial recovery. The proper guidance and approach can save you a substantial amount of money when taxes are due.
At Fuicelli & Lee, our team of Denver personal injury attorneys has helped injured clients across Colorado recover full and fair compensation. We understand the legal and financial implications of serious injury claims, and we know how to structure settlements to preserve value and minimize risk. If your case involves lost income, emotional damages, or any compensation that could affect your taxes, speak with a lawyer who can protect your future.
Call Fuicelli & Lee today at (303)444-4444 or contact us online to schedule a free consultation. They will help you understand your options and fight to protect everything you are owed.