Structured settlement payments received as compensation for personal physical injuries or physical sickness are entirely free from federal income tax, and so is the investment growth inside the annuity funding them. That is the general rule for the taxation of structured settlements, and it comes from Section 104(a)(2) of the Internal Revenue Code.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness The exclusion has sharp edges, though. Punitive damages, settlements for non-physical claims, and standalone emotional distress awards are taxable, and the wording of the settlement agreement often decides which bucket a payment lands in.
Payments That Arrive Tax-Free
Section 104(a)(2) excludes from gross income any damages received on account of personal physical injuries or physical sickness, whether paid as a lump sum or as periodic payments through a structured settlement.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness The exclusion covers every compensatory piece tied to the physical injury: medical bills, lost earnings, pain and suffering, and loss of consortium. As long as the damages flow from a physical injury or physical sickness, each payment arrives tax-free for the life of the settlement.
Workers’ compensation benefits sit under a separate provision, Section 104(a)(1), which excludes amounts received under workers’ compensation acts as compensation for personal injuries or sickness.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness A workers’ comp claim resolved through a structured annuity gets the same tax-free treatment.
A second benefit surprises many recipients. The investment growth inside the annuity funding the settlement is also tax-free. In an ordinary investment account, interest and gains are taxed as they accrue or when distributed. In a properly structured settlement, the recipient never owns or controls the annuity. The defendant or an assignment company holds the policy under a qualified assignment governed by Section 130, and the recipient simply receives payments as they come due.2Office of the Law Revision Counsel. 26 USC 130 – Certain Personal Injury Liability Assignments That tax-free compounding is one of the central financial reasons to take periodic payments instead of cash upfront.
Payments That Are Taxable
The exclusion stops at physical injury and physical sickness. Settlements for other kinds of harm are generally taxed as ordinary income, and spreading them out as periodic payments doesn’t change that. Each installment gets reported on the recipient’s tax return.
Punitive Damages
Punitive damages are taxable even when they come out of a case involving real physical injury. The statute explicitly carves them out of the exclusion.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness They get reported as other income on Schedule 1 of Form 1040.3Internal Revenue Service. Publication 4345 – Settlements Taxability One narrow exception: Section 104(c) preserves the exclusion in certain wrongful death actions where state law permits only punitive damages as the available remedy.4Internal Revenue Service. Tax Implications of Settlements and Judgments
Non-Physical Injury Claims
Settlements for employment discrimination, defamation, breach of contract, invasion of privacy, and similar claims are fully taxable. Real harm doesn’t change the result if the harm wasn’t physical. Structuring an employment discrimination recovery as periodic payments can soften the bracket impact by spreading income across years, but it buys no exclusion.
Emotional Distress
Emotional distress sits in an awkward middle ground. The statute says explicitly that emotional distress is not treated as a physical injury or physical sickness, so damages for standalone emotional distress claims are taxable. Two exceptions apply. First, if the emotional distress flows directly from a physical injury (for example, anxiety caused by a spinal cord injury), those damages share the physical injury’s tax-free status. Second, the statute carves out a limited exception for amounts paid for medical care attributable to emotional distress. Money used for therapy, psychiatric treatment, or medication escapes tax up to what was actually spent on that care.1Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness
Why the Settlement Agreement Wording Decides the Tax Outcome
The settlement agreement is the first document the IRS looks at when it classifies the payments. A well-drafted agreement allocates damages explicitly between the physical injury (tax-free) and any other components (taxable). Vague allocation invites the IRS to challenge the entire exclusion, and the agency will look through the labels to the nature of the underlying claim if the paperwork doesn’t match.
Timing matters just as much as allocation. Treasury regulations treat income as constructively received when it’s credited to your account, set apart for you, or otherwise made available so you could draw on it, even if you choose not to.5eCFR. 26 CFR 1.451-2 – Constructive Receipt of Income If a claimant first negotiates a lump sum and only later decides to put part of it into a structured settlement, the IRS treats the full amount as received in that year, and the entire sum becomes taxable. The decision to structure must be baked into the agreement from the start, with the claimant entitled only to periodic payments and no right to demand the underlying principal.
Attorney Fees on Taxable Settlements
For a tax-free physical injury settlement, attorney fees are a non-event. The contingency fee comes out of money that was never taxable, so nothing hits the recipient’s return.
Taxable settlements are harder. Under the assignment of income doctrine, the IRS attributes the full settlement amount to the recipient, including the slice paid directly to the attorney. Win a $500,000 employment discrimination settlement with a 33% contingency fee, and you report $500,000 in gross income even though $335,000 is what you actually take home.
Before 2018, the attorney fees could at least be claimed as a miscellaneous itemized deduction. The Tax Cuts and Jobs Act suspended that deduction starting in 2018, and the One Big Beautiful Bill Act of 2025 made the elimination permanent. There is no longer any path to deducting contingency fees as a miscellaneous itemized deduction on a taxable settlement.
One meaningful carve-out survives. Section 62(a)(20) allows an above-the-line deduction for attorney fees and court costs paid in connection with claims of unlawful discrimination, broadly defined to include claims under Title VII, the Age Discrimination in Employment Act, the Fair Labor Standards Act, the Americans with Disabilities Act, the National Labor Relations Act, the Family and Medical Leave Act, and several other federal statutes. Section 62(a)(21) extends the same treatment to attorney fees in whistleblower actions, including claims under the SEC whistleblower program and state false claims acts.6Office of the Law Revision Counsel. 26 USC 62 – Adjusted Gross Income Defined The deduction reduces adjusted gross income, which keeps the attorney fee portion from inflating your tax bracket and triggering phaseouts. It’s capped at the amount of settlement income included, so it can’t generate a loss, but it eliminates the problem of paying tax on money you never received. For taxable settlements outside the discrimination and whistleblower categories, the full assignment of income problem remains and no deduction is available.
Selling Future Payments for a Lump Sum
Recipients who later need cash sometimes sell future payment rights to a factoring company for a discounted lump sum. Every state except one has adopted a Structured Settlement Protection Act requiring court approval before the sale closes, and the court must find the transaction is in the recipient’s best interest.
Section 5891 of the Code adds a federal enforcement layer: a 40 percent excise tax on any person who acquires structured settlement payment rights in a factoring transaction. The tax falls on the factoring company, not the recipient, and is calculated on the factoring discount, meaning the difference between the undiscounted value of the payments and the amount actually paid to the recipient. The excise tax doesn’t apply when the transfer is approved in advance by a qualified order, which is a court order finding that the transfer doesn’t violate any federal or state law and is in the best interest of the payee.7Office of the Law Revision Counsel. 26 USC 5891 – Structured Settlement Factoring Transactions The 40 percent penalty is what pushes factoring companies through the court process.
For the recipient’s own tax picture, the character of the lump sum follows the character of the underlying settlement. If the original structure was for personal physical injuries and excluded under Section 104(a)(2), a court-approved sale generally preserves the tax-free treatment, so the cash arrives tax-free the same way the periodic payments would have. If the underlying settlement was taxable, the sale proceeds are taxable too. The bigger cost is almost always the factoring discount itself, which can take a large bite out of the payment value regardless of how the tax treatment comes out.
What Happens When the Recipient Dies
Many structured settlement annuities include a guarantee period or a provision naming a beneficiary for continued payments. When the original settlement qualified under Section 104(a)(2), the remaining payments continue to be excluded from income for the beneficiary or the estate. The tax-free character attaches to the payments based on their origin as damages for physical injury, not to who ends up receiving them.
Because the recipient never owned the annuity under the qualified assignment, no annuity contract flows through the estate in the usual sense. The assignment company keeps paying whomever the settlement agreement designates. The annuity’s value can still factor into federal estate tax if the estate is large enough to owe it, but the income tax exclusion on the periodic payments themselves survives the recipient’s death.