For U.S. federal income tax, compensation received because of physical injuries or physical sickness is generally excluded from income. That can include related emotional distress and lost earnings caused by the physical injury; lost earnings are not automatically taxable just because of their label. Important exceptions remain. Punitive damages and settlement interest are generally taxable, and reimbursement of medical expenses previously deducted may be taxable to the extent that the earlier deduction produced a tax benefit.

Keep the settlement agreement, payment breakdown, tax forms and records of earlier medical deductions. Ask a qualified tax adviser to review the payment’s actual purpose, any taxable components and the applicable state tax treatment before you file. A single cheque may cover several categories, and wording in an agreement cannot by itself change what the money compensates for. The firm’s explanation of economic damages helps distinguish financial losses from other damages, but calculating a claim and determining its tax treatment are separate tasks.