Is my personal injury settlement taxable?

Settlements can be very large, and no one wants to be surprised by losing a large chunk of their settlement to taxes. Knowing what will happen with your settlement can help you understand your personal injury claim and ease your mind throughout the process.

Do you pay tax on an injury settlement?

The quick answer to this question is no. The Canada Revenue Agency (CRA) typically does not consider compensation received in personal injury claims as taxable income.

The Income Tax Act

The Income Tax Act outlines what the Government decides to tax as personal income throughout Canada. Specifically, section 81(1)(g.1), which indicates that personal injury awards are not “income” for taxation purposes.

The CRA (through Bulletin IT-365R2) does not consider most personal injury awards “income.” This means that your personal injury settlement likely won’t be taxed. However, there are exceptions to this rule.

Why is my settlement money exempt from taxation?

Personal injury claims can be exempt from taxation for several reasons, the first being the concept of pain and suffering compensation. Pain and suffering awards are typically monetary, but this money is a way to financially compensate you for your diminished quality of life because of the accident.

Second, your settlement money isn’t taxable because of how lawyers calculate it. Personal injury claims often cause a loss of income from an inability to return to work. That loss of income is usually calculated on a net basis, meaning your lost wages account for any tax deductions you would have if you were working. In other words, by the time you receive this compensation, you have, in theory, already paid taxes on it.

A cautionary note

If your personal injury settlement includes things other than special damages (out-of-pocket expenses) or general damages (pain and suffering), you might have to pay taxes on that portion.

These instances could include a guaranteed severance payment or compensation that could be considered employment income. However, in these situations, it is just the portion of the settlement that appears income-like that is taxed. Both the special and general damages portions are still exempt.

To put this into context, if you can no longer work, you may be awarded a severance payment as part of your settlement. That payment likely constitutes a source of employment income, as it is a standard form of compensation paid to an employee when their employment is severed. As a result, that amount of your settlement will likely be taxable.

However, your settlement may consist of other forms of compensation like special damages or pain and suffering damages, as mentioned above, that will not be taxed.

Investing your settlement?

While the settlement itself is likely to be exempt from taxes, this does not mean that everything you do with your compensation will be exempt from taxes. Often, clients want to invest a portion of their settlement. While this can be a smart undertaking, you must know the tax implications of doing so.

If you’re investing your settlement money, the gain you receive is taxable income, as long as you are older than 21. For those under 21, the capital gain or investment income you receive is also likely tax-exempt. This tax exemption extends to the end of the taxation year in which you turn 21 years old. After this age, the exemption no longer applies, making your profit taxable.

For example, say you invest $20,000 of your settlement into the stock market and earn a 20% return. In this case, the $4,000 gain you see will be taxable. Just because the initial money you invested was from a non-taxable source does not mean the future investment gains are tax-exempt.

Making a structured settlement exempt

While settlements are often lump-sum payments, this is not always the case. Some people choose to receive payments over an extended duration of time instead.

The CRA has listed criteria in which a structured settlement creates payment amounts that are not taxed. A structured settlement is an arrangement where you agree to resolve your claim by receiving your settlement as periodic payments instead of a lump sum amount. Essentially, what would have been a lump sum payment becomes a monthly, weekly, bi-weekly, or other agreed-upon time frame payment.

Clients can discuss structured settlements with their lawyer if they feel it’s the right avenue.

Example of an exempt personal injury award

Below is an example in which your entire personal injury settlement would be exempt from taxes:

As a result of a car accident, you have sustained multiple injuries and settle for $150,000. This lump sum award is composed of loss of income and pain and suffering. Given the nature of the payment, the entire $150,000 would be exempt from taxes.

As you can see, even though your personal injury award is likely to be exempt from taxes, it can still be a tricky concept to understand. Such difficulty makes it crucial to discuss your potential settlement with a lawyer. By doing so, you will be able to understand your personal injury claim and any settlement associated with it before getting too deep into the process and being surprised by the sudden loss of a large portion of money due to taxation.