In most cases, you do not have to pay taxes on personal injury settlements in New Mexico, especially for compensation related to your physical injuries. The government generally views this money not as income, but as a way to restore what you lost. However, there are important exceptions, and certain parts of a settlement, like punitive damages or interest payments, can be considered taxable.
Dealing with the financial side of a settlement can feel just as complex as the legal journey you’ve already been through. Knowing which parts of your settlement might be considered taxable income by the IRS and which parts are not is essential for planning ahead.
Key Takeaways
- Compensation received for physical injuries or physical sickness is generally not considered taxable income by the IRS.
- Settlement portions specifically awarded for punitive damages, which are meant to punish the at-fault party, are typically taxable.
- Any interest earned on a settlement award is also considered taxable income.
- Damages for emotional distress may be taxable if they are not directly caused by a physical injury.
- The specific language used in the settlement agreement can significantly impact how the funds are treated for tax purposes.
- New Mexico’s state tax laws generally align with federal guidelines regarding the taxability of personal injury settlements.
The General Rule: Why Most Settlement Money Is Tax-Free
For most people dealing with a personal injury claim, there is good news. The federal government, through the Internal Revenue Service (IRS), has established a general rule that compensation received for personal physical injuries or physical sickness is not taxable. You can find this principle outlined in federal law, specifically in 26 U.S. Code § 104. The core idea behind this rule is that you are not gaining income; you are being made whole again after a loss. The settlement is meant to restore you, as much as possible, to the position you were in before the injury occurred.
This non-taxable category covers what are known as compensatory damages. These are funds intended to compensate you for the actual losses you suffered. Think of it as reimbursement for the tangible and intangible costs of your injury.
Common types of non-taxable compensatory damages include payments for:
- Medical Bills: This covers everything from the initial emergency room visit to ongoing physical therapy, medications, and any future medical care related to the injury.
- Lost Wages: If your physical injury prevented you from working, the portion of your settlement that reimburses you for the income you lost is typically not taxed.
- Pain and Suffering: This compensates you for the physical pain and discomfort you endured because of the injury.
- Emotional Distress: Funds for anxiety, depression, or sleep loss are also generally not taxable, as long as they stem directly from the physical injury.
These categories represent the foundation of most personal injury settlements, providing financial relief that is rightfully yours without the extra burden of taxes.
When Your New Mexico Settlement Might Be Taxable
While the general rule is a comfort, there are important exceptions where a portion of your settlement could be subject to taxes. Knowing these exceptions is crucial for avoiding any surprises when tax season arrives. The distinction often comes down to the purpose of the money you receive. If the payment is not meant to compensate for a physical injury, the IRS may view it differently.
Punitive Damages: A Closer Look
In some cases, a court may award punitive damages. Unlike compensatory damages that cover your losses, punitive damages are designed to punish the defendant for particularly reckless or egregious behavior and to deter others from acting similarly. Because this money is not meant to make you whole but rather to penalize the wrongdoer, the IRS considers it a financial gain.
Therefore, any portion of your settlement that is specifically identified as punitive damages is almost always taxable income. It's important that your settlement agreement clearly separates punitive awards from compensatory ones.
Emotional Distress Without Physical Injury
The source of emotional distress is a key factor for the IRS. As mentioned, if your emotional suffering is a direct result of a physical injury—for example, developing anxiety after a serious car crash on I-25—the compensation is typically not taxable.
However, if your legal claim is only for emotional distress and does not involve any physical injury or sickness (such as in a defamation or harassment case), the settlement you receive is usually considered taxable. The physical link is what shields the compensation from taxation in the eyes of the IRS.
Interest on Your Settlement
Personal injury cases can sometimes take years to resolve. From the time a judgment is entered to the time you actually receive the payment, interest may accumulate on the settlement amount. While the principal settlement for your physical injuries remains non-taxable, any interest paid on that amount is considered taxable income. This is because interest is viewed as investment income, separate from the compensation for your injuries.
Understanding How Your Settlement Agreement Affects Your Taxes
The words used in your final settlement agreement matter immensely. A well-drafted agreement will clearly allocate the settlement funds to different categories of damages. For example, it should specify how much is for medical expenses, how much is for pain and suffering related to physical injuries, and if any amount is for punitive damages.
This level of detail can be incredibly helpful. If the IRS ever questions the tax-free status of your settlement, a clear and specific agreement provides documentation showing that the funds were intended as compensation for physical injuries. Without this specific language, the IRS might make its own determination about the purpose of the funds, which could lead to unexpected tax liabilities. This is one of many areas where the guidance of an experienced legal team can be invaluable in protecting your long-term financial health.
New Mexico State Taxes vs. Federal Taxes
So far, we have focused on federal tax rules from the IRS. What about taxes here in New Mexico? Generally, the State of New Mexico follows the federal government’s lead when it comes to defining taxable income. If your settlement is not taxable at the federal level, it is highly unlikely that you will have to pay New Mexico state income tax on it.
Our state’s tax system bases your state liability on your federal adjusted gross income. Therefore, money that is excluded from your federal income, like compensation for a physical injury, is typically excluded from your state income as well. This alignment simplifies things for residents from Albuquerque to Los Lunas and across the state, ensuring that the financial relief you receive is not diminished by state taxes. For more detailed state-specific information, you can always refer to the New Mexico Taxation and Revenue Department.
Practical Steps to Take After Receiving a Settlement
Receiving your settlement check is a significant moment, but there are a few steps you should consider taking to manage your finances responsibly and prepare for the future. Being proactive can help ensure your settlement serves its purpose of providing long-term security.
- Review Your Settlement Agreement Carefully: Before you even deposit the check, take the time to review the final agreement one more time. Understand how the funds are allocated and keep a copy for your records. This document is your primary evidence of the settlement's purpose.
- Consult with a Financial Professional: While a personal injury attorney is your advocate in the legal system, a qualified tax advisor or financial planner can provide guidance on managing the settlement funds. They can help you understand any potential tax implications and plan for your future financial needs.
- Keep Meticulous Records: Hold onto all documents related to your injury and settlement. This includes medical bills, records of lost wages, and the settlement agreement itself. These documents are essential if you ever need to justify the tax-free nature of your settlement.
Taking these thoughtful steps can help you transition smoothly into the next chapter of your life with the financial foundation you need to heal and move forward.
FAQ for Do You Pay Taxes on Personal Injury Settlements in New Mexico?
Here are answers to some other common questions people have about personal injury settlements and taxes in our state.
What happens if I deducted medical expenses on my taxes in a previous year and my settlement reimburses me for them?
If you claimed a tax deduction for medical expenses in a prior year and then received a settlement that reimburses you for those same expenses, you will likely need to report that portion of the settlement as "other income" on your tax return. You only have to report the amount that you received as a tax benefit in the past.
Is a wrongful death settlement taxable in New Mexico?
Similar to personal injury cases, wrongful death settlements that are compensatory in nature are generally not taxable to the surviving family members. However, if a portion of the settlement is allocated to punitive damages or to the decedent's estate for things like lost wages before death, those amounts could be taxable.
How does the IRS find out about my settlement?
The defendant or their insurance company will often issue an IRS Form 1099-MISC if any portion of your settlement is considered taxable income, such as for punitive damages or interest. This form is sent to both you and the IRS, reporting the payment.
Does it matter if I receive my settlement as a lump sum or as structured payments?
The tax treatment of the funds generally remains the same whether you receive them all at once or in periodic payments (a structured settlement). The portions for physical injury are non-taxable. However, any growth or interest earned on the funds within a structured settlement annuity may be treated differently, so it's wise to discuss the structure with a financial advisor.
If I used part of my settlement to pay my attorney's fees, is that portion taxable?
The IRS does not allow you to deduct attorney's fees for non-taxable settlements. The entire portion of the settlement designated for physical injuries is non-taxable, regardless of how much went to legal fees. If part of your settlement is taxable (like punitive damages), you may be able to deduct the corresponding legal fees, but the rules are complex.
Navigating Your Financial Recovery with Confidence
Understanding the tax implications of a personal injury settlement is a critical part of protecting your financial recovery. While the process can seem intimidating, you don’t have to figure it all out on your own. Ensuring your settlement is structured properly from the start can make all the difference in preserving the funds you need to move forward.
At Gauthier & Maier Law Firm, P.C., we are dedicated to supporting our clients in Albuquerque, Los Lunas, and throughout New Mexico through their legal battle and by helping them understand what comes next. Our client-centered approach means we are here to answer your questions and provide the clarity you deserve.
If you have been injured and are concerned about your legal rights and financial future, contact us today at (505) 226-0009 or through our online form for a free consultation. Let us help you navigate this complex journey with the advocacy and care you need.