Do you have to pay taxes on insurance settlements? Well, that’s simple. The general rule is that insurance settlements are not taxable. This is because insurance settlements are intended to compensate you for your losses rather than provide you with a profit. However, there are a few exceptions to this rule. Let’s go over these exceptions and every detail you should know about taxes and insurance settlements.
Key Takeaways
Exceptions to the general rule behind insurance settlements and taxes include the following:
- One exception is if you receive an insurance settlement for punitive damages. Punitive damages are awarded to punish the defendant for their wrongdoing rather than to compensate the plaintiff for their losses. Punitive damages are taxable.
- Another exception is if you receive an insurance settlement for lost wages. Lost wages are taxable, even if you receive them from an insurance settlement.
- Finally, if you receive an insurance settlement for damages that you have already deducted from your income tax return, you may have to pay taxes on the settlement. This is because you are essentially being compensated for the same loss twice.
Do I Have to Pay Taxes on My Insurance Settlement?
Generally, money received as part of an insurance claim or settlement is not taxable. The IRS only taxes income, which is money or payment received that results in you having more wealth than you did previously.
Because insurance aims to “make you whole,” you should only receive enough money to return you to your pre-incident state. For instance, you may receive a large reimbursement from an insurer to repair your car, but if the money is exclusively used to restore your car to its pre-accident condition, it is not taxable.
On the other hand, income from certain types of claims and insurance-related events may still be taxable.
Types of Claims & Insurance that May or May not be Taxable
#1. Claims to Repair or Replace Your Home, Car, or Other Property Are Not Taxed
One of the most common reasons for receiving money from an insurance claim is to pay for repairing or replacing damaged property. This could be a car insurance claim paying to repair your vehicle after an accident, homeowners insurance paying to repair your house after a natural disaster, or renters insurance paying for personal property stolen from you.
In all of these cases, you do not have to pay taxes on the compensation because you are not gaining anything; you are simply being returned to the state you were in before the incident.
Assume you own a $10,000 car that is totaled in an accident. After the claim is settled and you are compensated with $10,000 towards a new car (less the deductible), you are back to where you started. You haven’t gained or earned any money, so the IRS won’t charge you.
The only exception is if you have leftover funds from your claim after your property has been replaced or repaired. This can happen in two ways:
- If the insurance company overpaid you.
- If you did the repair yourself and paid yourself.
#2. Medical Claims Are Not Taxed
Any medical claim you make to insurance, whether as part of a settlement after an accident or simply for a medical appointment, will not be taxed.
For example, if you are in a car accident and incur $500 in medical expenses, your personal injury protection (PIP) coverage will reimburse you. However, because the $500 only reimburses you for money you have already spent, you are not required to pay taxes.
When filing a health insurance claim, you won’t see any money because health insurance companies typically pay doctors directly. However, if you pay for a medical expense out of pocket and are later reimbursed, you will not have to pay taxes on the amount you are paid.
You can save even more on medical bills and taxes by paying them with a flexible spending account, or FSA. FSAs are typically provided as a perk through your employer.
When you sign up for an FSA, you agree to set aside a certain amount of pretax money each year for medical expenses. It can be used to pay deductibles and coinsurance for doctor’s visits, prescriptions, and other expenses.
#3. Insurance Claims for Life and Disability May Be Taxed
A life insurance payout is not taxed as income because it is distributed after the insured person dies. However, depending on the size of the insured’s estate, it may be subject to estate taxes. The state where the insured and beneficiaries reside may levy an estate or inheritance tax.
Furthermore, any interest earned on a life insurance payout or any money withdrawn from a cash-value life insurance policy while the insured person is still alive is considered income and is taxed accordingly.
Short-term and long-term disability insurance proceeds, which are both intended to provide you with income if you are unable to work, are taxed in the same manner as income. When you file your taxes, you must include these payments as earnings.
#4. The Proceeds of a Lawsuit May Be Taxed
If your insurance claim becomes a lawsuit, the tax situation becomes more complicated because you may receive several types of compensation, all of which may be taxed differently.
Compensation for medical bills and property repair is not taxed in a lawsuit, just like it is not in an insurance settlement. Some types of payouts you may receive as a result of a legal settlement, however, are taxable, regardless of whether the case is ultimately settled in or out of court.
For example, if you are hit in a car accident, you will not be taxed on any money you receive for medical bills. However, if the judge also awards you punitive damages, you must also pay tax on those. If you receive taxable payments due to a lawsuit, you will most likely be given a 1099 form for filing your taxes.
Common taxable lawsuit settlements include:
- Lost wages
- Punitive damages
- Emotional distress
- Pain
Car Accident Settlement Taxes
Some insurance settlements for car accidents are taxable. The portion of the settlement that compensates you for medical bills, pain and suffering, and property damage, on the other hand, is not taxable. However, the car accident insurance settlement is taxable if you recover lost income.
Depending on how you label and structure your settlement, only certain portions of a car accident insurance settlement may be taxable. This is why consulting with a legal professional is critical before settling your case.
How can I get my car accident settlement taxes reduced?
You can avoid paying car accident settlement taxes by structuring your settlement in a way that avoids tax liability. For example, if you receive compensation for medical expenses, it is not taxed. If possible, the parties can work together to classify the settlement for medical purposes.
Furthermore, labeling a settlement as compensation for pain and suffering exempts it from taxation because pain and suffering are a result of physical injuries. Even if you have a tax liability, you can reduce it by spreading payments out over several years so that your total taxable income does not exceed a certain threshold in any year.
Insurance Settlements for Car Accidents That Are Not Taxed
The following types of car accident insurance settlements are not taxed:
- Emergency medical expenses
- Medical attention
- Medical equipment
- Prescriptions
- Surgeries and diagnostic tests
- Work in the laboratory
- Rehabilitation therapy
- Damage to property
- Compensation for pain and suffering
Insurance Settlements for Car Accidents That Are Taxed
The following types of car accident insurance settlements are taxed:
- Lost wages
- Lost long-term income
- Interest
- Punitive damages
Is Income Tax Levied on Punitive Damages?
Yes, punitive damages are taxable income. According to IRS Publication 4345, punitive damages are taxable and must be reported as income. Punitive damages must be reported as “other income” under US federal tax law. They must be reported on a 1040 tax form, and the recipient is required to pay taxes on the payments as if they were income.
Are settlements for property damage taxable?
No, settlements for property damage are not taxable. You do not have to pay taxes on the settlement amount if you receive a payment for property damage. This is because you are being compensated for the property’s diminished value. If you were taxed on that amount, you would no longer be compensated in full for the total loss caused by the accident. It is only fair, according to tax laws, not to tax a victim for a property damage settlement.
How Can a Lawyer Assist With Car Accident Settlement Taxes?
Working with an experienced attorney before settling your car accident claim can save you money on taxes. Assume you receive $100,000 in compensation for lost wages and future earnings. As a single filer, your highest tax bracket is 24% if you accept the payment in full. That means you’ll be paying income tax at a rate of 24% on a portion of your earnings!
However, suppose you decide to spread the payments out over five years. You will be paid $20,000 per year for the next five years. In that case, the top tax bracket is 12%. You can save 12% tax on a portion of your settlement by deferring payments for a period of time.
Are car insurance settlements taxable in no-fault states?
If you live in a no-fault state, taxation issues can become complicated.
For example, people injured in a car accident in Michigan must first contact their insurance company under the state’s no-fault insurance law. That insurance company is liable for up to three years of lost wages. These lost wages are paid at 85% of what the individual would have made if they had not been injured, and this portion of the settlement is not taxable.
However, if that same person is still disabled after three years, a claim for excess economic loss can be made against the person who caused the car accident.
Is the interest you earn on your auto accident settlement taxable?
If you receive a large settlement, you may decide to put some of the money in a bank account or mutual fund to earn interest. In this case, you must include any interest earned on your tax return because it is considered income and is always taxable.
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