Texas has a unique tax structure, and Houston residents benefit from the fact that there’s no state income tax. This means personal injury settlements aren’t taxed at the state level. But before you breathe a sigh of relief, there’s more to the story.
Federal tax laws still apply to the proceeds of your personal injury lawsuits in Houston, TX, and some parts of your settlement might be taxable, depending on how it’s classified. You should hire a personal injury lawyer to help you understand how these laws apply to your case so you can avoid surprises when tax season rolls around.
Are Personal Injury Settlements Taxable in Texas?
If you receive a settlement for a personal injury case in Texas, the good news is that most of it is tax-free. Whether you settle privately or win your case in court, any compensation for physical injuries or sickness is exempt from taxes. That means money awarded for medical expenses, lost wages, and pain and suffering related to a physical injury won’t be taxed.
It doesn’t matter if you take the money as a lump sum or receive it in periodic payments—the tax treatment remains the same.
Exceptions to the Rule: What Parts of a Settlement Can Be Taxed?
While most personal injury settlements are tax-free, there are some exceptions. Certain types of compensation fall outside the tax-exempt category and may be subject to federal taxes.
These include:
Punitive damages
Unlike compensatory damages, which are meant to reimburse you for losses, punitive damages are designed to punish the defendant for bad behavior.
The IRS considers these taxable income, so if your settlement includes punitive damages, you’ll owe taxes on that portion.
Emotional distress (without physical injury)
If you receive compensation for emotional distress but did not suffer a physical injury or illness, the money is taxable. However, if the emotional distress is directly tied to a physical injury, it remains tax-free.
Medical expenses (if previously deducted)
If you deducted medical expenses related to your injury in previous tax years and later receive a settlement covering those expenses, that portion of your settlement becomes taxable. This is to prevent people from benefiting twice from the same expense.
Interest on the settlement
Sometimes, settlements take months or even years to finalize, and during that time, interest may accumulate on the awarded amount. This interest is considered taxable income, even though the settlement itself might not be.
What About Federal Taxes?
Since Texas doesn’t have a state income tax, the main concern for Houston residents is federal taxation. The IRS follows specific guidelines for taxing personal injury settlements under Internal Revenue Code (IRC) Sections 61 and 104.
These sections explain that all income is taxable unless an exemption applies, and luckily, personal injury settlements fall under one of those exemptions most of the time.
If you’re receiving Social Security Disability benefits along with a personal injury settlement, your tax situation gets more complicated. The IRS considers half of your disability benefits when calculating taxable income.
If your total income exceeds certain thresholds ($25,000 for single individuals, $32,000 for married couples), part of your Social Security benefits may be taxable as well.
The key question is: What was the purpose of the settlement money? If it was meant to compensate you for medical bills, wages that were lost, or pain and suffering from a physical injury, then it’s not taxable.
But if it includes punitive damages, interest, or compensation unrelated to physical harm, you may have to report it as income.
The Bottom Line
If you’re receiving a personal injury settlement in Houston, Texas, the good news is that most of your compensation will be tax-free, thanks to both state and federal laws.
However, certain parts of your settlement, such as punitive damages, interest, and emotional distress unrelated to a physical injury may still be subject to federal taxes.
