Insurance agents for both local and national companies are often asked by customers if there is an insurance settlement with a claim they had, do they need to pay a tax for it? Like so many things with insurance, the answer depends on the case.
The short answer is that there are some aspects of insurance settlements that are taxable and others that are not. It’s crucial to understand which parts of your compensation are taxable, especially if you want to keep up with the IRS. Consider this your tell-all guide to taxable insurance settlements.
Things to Know About Taxability And Car Accident Settlement
Talking about taxes can be confusing with all the bureaucratic terminology and regulations. Sometimes the answer of whether or not you have to pay taxes on something isn’t always clear. We can tell you right out of the gate that the IRS only taxes income that increases your net worth or wealth.
This is why, for example, they tax a certain amount of winnings from a casino. As a general rule of insurance, funds that were used to fix or even replace your vehicle aren’t taxable.
However, what is considered emotional damage from a car accident may be taxable, depending on the payout. A major insurance coverage that is taxable is worker’s compensation.
Why Are Some Insurance Settlements Taxable?
You can possibly tell when an insurance settlement will be taxed. Your auto insurance coverage isn’t designed to earn you a profit when you file a claim. It’s meant to reimburse you for repair or medical treatment costs after an accident. If all goes well, you will recieve a payout that leaves you right where you were before the accident, finances-wise.
Remember that the IRS only taxes significant changes to your wealth or net worth. This is why insurance payouts for damage aren’t often taxed while payouts for emotional suffering are. It all depends on your settlement details.
What Are Examples of a Car Accident Settlement?
Let’s look at an example of an auto insurance settlement in order to see what would be taxable.
Let’s say that you damage your car, and repairs are $6,000. You are also injured and have to miss work for a period of time, resulting in around $4,000 in lost wages and $5,000 in medical bills.
Your auto policy also covers pain and suffering caused by accident, which is around $7,000. This adds up to a total insurance settlement of $22,000. The question is, what part of this settlement will be taxed?
First, the repair or replacement of your car will not be as there is not an increase in wealth or a profit from this payout. It is intended to be enough to get you back to the financial position before your accident. The same is said for the coverage for your medical bills.
However, your worker’s compensation for missing work and settlement for pain and suffering increases your wealth because you did not have this money at the time of your accident. Therefore, the IRS will tax you for them. This would mean that $11,000 of your $22,000 settlement is taxable.
Here is What is Taxable From a Settlement
To review, here is what is and isn’t tax-exempt in an insurance settlement:
- Car repair/replacement - Tax exempt
- Lost wages - Taxable
- Medical bills - Tax exempt
- Physical pain/suffering - Tax exempt
- Emotional pain/suffering - Taxable
Why Car Repair/Replacement is Tax Exempt
The most common scenario in which you may receive compensation for a vehicle insurance claim is following damage or loss caused by an accident. It may be to repair or replace your automobile after a collision, but it can also cover acts of vandalism and other sorts of vehicle damage. This money is not taxable compensation. You aren’t financially better off after the lawsuit; therefore, this cannot be considered income.
Why Lost Wages Are Taxable
Your pay from work is taxed, so any new pay will also be taxed. A major vehicle accident might result in significant injuries, and if you are unable to work, your insurance company may pay you compensation.
In most cases, this money will be taxed since it will be regarded as income rather than reimbursement. Compensation for lost earnings is meant to replace the income you would have earned had you not been harmed.
If you don’t make a full recovery, you may be compensated for future missed earnings. Taxes on missed income might be complicated; you may wind up paying a higher tax rate than you would have if your contract is structured properly.
Why Medical Bills Are Tax Exempt
Your insurance company will generally pay the hospital directly or simply reimburse you for medical expenses you have already paid, which are not considered income. This is often covered by your personal injury protection insurance if you were at fault for the accident.
The IRS lists one notable exception, however, where you may be taxed for medical bills. Insurance payouts for medical reasons are typically taxable when a certain amount is deducted for a tax benefit. Any previous medical deductions are also paid for in the same year of the settlement. Note that you are only allowed to make a medical deduction if it exceeds 10% of your income.
Why Pain And Suffering Settlements Can be Taxable
Pain and suffering on account of a physical injury aren’t normally taxable. You would have to pay for something like medication under normal circumstances, so it doesn’t qualify as income.
When the pain and suffering settlement is made based on emotional damage, then it becomes taxable. This is because you paid for an attorney’s service and have to pay a tax on that. The settlement you’re entitled to then qualifies as income.
Can You Reduce The Tax You Owe After a Settlement?
There are a couple of routes to take in order to pay less on the taxes you owe or even have them dropped altogether. By hiring a lawyer, they can help you in the following ways.
Structured Car Insurance Settlement
If you are entitled to a large settlement, then you can elect to have it paid out as a structured settlement. This means that you’ll be getting your money gradually over a period of time instead of all at once. This allows some of the settlement to be tax-exempt.
Your car insurance provider uses an annuity with interest that accumulates. It’s the money that is paid out by the annuity and not the insurance company that is tax-exempt. You would list this on the 1099 Form when you do your taxes. Those that opt for a structured settlement save up to 35%.
Damage Classification in Settlement
If you were to sue a driver, the damages they caused are classified as general damage or special damage. Damage classification actually plays a role in determining whether or not there are taxes to be paid.
Special damage is things such as lost wages which are usually taxable. Meanwhile, general damages are things like physical injuries, pain, and suffering (more subjective). These ones are less likely to be taxed. Ironically, special damage is easier to quantify than general damage.
In conclusion, if you’re not entirely sure what part of your insurance settlement is taxable, consult with an attorney. Remember the golden rule as well; if it increases your net worth or acts as income, then it is not tax-exempt.
Don’t let one collision drain you financially; get affordable SR-22 coverage today. Insurance Navy offers free quotes online via our website and mobile app. You can also give us a call at 888-949-6289. More assistance may be offered in person at one of our many conveniently-located storefronts.