Interest on damages in legal settlements is extra money added to a judgment or settlement to compensate you for the time between when you were harmed and when the defendant actually pays. The IRS treats that interest as taxable income, even when the underlying award itself is tax-free.1Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined The rate, the method of calculation, and the exact tax consequences depend on whether your case was in state or federal court and what kind of claim produced the award.
Lawsuits take time. During that time the defendant is holding money that rightfully belongs to you, and a dollar paid years from now is worth less than a dollar paid today. Interest on damages closes that gap. It is separate from the compensatory or punitive damages the court awards for the actual injury or breach, and it appears as its own line in a properly itemized settlement.
A quick boundary before going further: accountants sometimes use “interest on drawings” (also abbreviated IOD) to describe a charge applied when a partner withdraws funds from a business partnership. That usage has nothing to do with litigation and is not what the IRS or a court means by interest on a judgment.
The Two Phases of Interest
Interest on a legal award accrues in two separate phases, and most settlement statements show them as separate numbers.
Pre-judgment interest covers the stretch from the date of the loss (or in some cases the date the suit was filed) up to the day the court enters a final judgment. That phase can span years of discovery, motions, and trial. Many jurisdictions now treat pre-judgment interest as an ordinary part of compensatory damages in most cases, rather than limiting it to claims where the dollar amount was fixed and easy to calculate from the start.
Post-judgment interest starts the moment the court enters the final judgment and keeps running until the defendant actually pays. If the losing side appeals, the meter keeps ticking the whole way through the appellate process.2Office of the Law Revision Counsel. 28 USC 1961 – Interest That ongoing clock is what pushes defendants to pay promptly rather than drag things out.
How the Dollar Amount Is Calculated
Three inputs drive the number: the principal judgment amount, the applicable interest rate, and the number of days interest has been accruing. Interest is normally computed on a daily basis so the payoff is precise whenever the check actually clears.
State Court Rates
Each state sets its own rate by statute. Some fix a flat percentage, with ten percent per year being common; others tie the rate to a market benchmark like the federal prime rate plus a set margin. Many state courts apply simple interest, which means the rate is applied only to the original judgment amount and the balance does not grow on itself over time. You can find the applicable rate in your state’s civil procedure code or post-judgment interest statute.
Federal Court Rates
In federal civil cases, the post-judgment rate is the weekly average one-year constant maturity Treasury yield published by the Federal Reserve for the calendar week before the judgment date.2Office of the Law Revision Counsel. 28 USC 1961 – Interest That number moves with the market and is generally lower than the flat statutory rates many states use. Federal post-judgment interest is computed daily and compounded annually, so each year’s accrued interest is folded into the balance for the next year’s calculation. The Administrative Office of the United States Courts distributes the current rate to federal judges.
How the Interest Is Taxed
The underlying damages and the interest are taxed under different rules. The interest itself is always taxable. Federal tax law lists interest as a category of gross income, and there is no exception for interest attached to a legal award.1Office of the Law Revision Counsel. 26 USC 61 – Gross Income Defined
Physical Injury Awards
Damages received on account of a personal physical injury or physical sickness are generally excluded from gross income.3Office of the Law Revision Counsel. 26 USC 104 – Compensation for Injuries or Sickness That exclusion covers the compensatory portion of the award. It does not cover the interest. Even if the underlying settlement is entirely tax-free, you owe income tax on every dollar of pre-judgment and post-judgment interest included in the payment.4Internal Revenue Service. Settlements – Taxability
Non-Physical Injury Awards
When the claim is for something other than a personal physical injury, such as employment discrimination, breach of contract, defamation, or emotional distress not caused by physical injury, the entire award is taxable as ordinary income. The IRS has confirmed that damages for emotional distress, back pay, and similar non-physical claims do not qualify for the Section 104(a)(2) exclusion.5Internal Revenue Service. Tax Implications of Settlements and Judgments In those cases the interest just adds to a payout that was already fully taxable.
Reporting the Interest on Your Return
Report settlement interest on line 2b of Form 1040 as interest income.4Internal Revenue Service. Settlements – Taxability If your total taxable interest for the year exceeds $1,500, you must also file Schedule B.6Internal Revenue Service. About Schedule B (Form 1040), Interest and Ordinary Dividends On a sizable judgment with years of accrued interest, you will almost certainly cross that threshold.
The entity cutting the check (usually an insurer or the defendant’s legal team) is required to report the interest portion to the IRS. When the payer is a bank or financial institution, the interest is typically reported on Form 1099-INT if it exceeds $10.7Internal Revenue Service. About Form 1099-INT, Interest Income In other situations the interest may be included in the total reported on Form 1099-MISC. The IRS gets a copy either way, so leaving it off your return invites penalties and back taxes.
Look closely at how your settlement check is broken down. If the payer does not separate the interest from the damages, ask your attorney or the paying party for an itemized statement before you file. You need the exact split between tax-free damages and taxable interest to report accurately.
Attorney Fees Attributable to the Interest
If your attorney took a percentage of the total recovery, part of that fee came out of the taxable interest. Under current law, legal fees paid to produce or collect taxable income are classified as miscellaneous itemized deductions, and those deductions are suspended through at least 2025.8Internal Revenue Service. Publication 529, Miscellaneous Deductions One narrow exception: for claims involving unlawful discrimination, such as Title VII employment cases, attorney fees can be deducted as an adjustment to income, up to the amount of the judgment or settlement included in your taxable income. For most personal injury plaintiffs, though, the attorney’s cut of the interest portion is not deductible, which means you owe tax on the full interest amount even though you did not keep all of it.
If You Are the One Paying the Interest
Deductibility on the paying side depends on whether the underlying obligation is personal or business-related.
- Personal judgments. Federal tax law disallows deductions for “personal interest,” which includes interest on debts not tied to a trade or business, investment activity, or a qualified residence. Interest paid on a personal injury judgment or a personal dispute generally falls into this non-deductible category.9Office of the Law Revision Counsel. 26 US Code 163 – Interest
- Business judgments. If the judgment arose from the taxpayer’s trade or business, such as a commercial contract dispute or a workplace injury claim, the interest portion may be deductible as an ordinary and necessary business expense. Interest on judgments paid to a government entity for a legal violation is generally not deductible, with narrow exceptions for restitution or compliance payments.10Office of the Law Revision Counsel. 26 US Code 162 – Trade or Business Expenses