Do I Have to Pay Taxes on a Car Insurance Settlement?
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If you receive a car insurance settlement stemming from an accident, you are likely wondering if you will have to pay taxes. The answer to this question is yes, but fortunately, not all of your settlement will be taxed.
The Internal Revenue Service (IRS) states that if a settlement is received for a personal injury and you do not take an itemized deduction for the related medical expenses in previous years, the entire amount of the settlement is non-taxable. This means the settlement amount should not be included in your income.
This seems pretty clear-cut, yet there are some exceptions. Most settlements these days will have some elements that need to be taxed. Therefore, taxes should be considered when you negotiate your settlement if you want to keep the bulk of the money that is paid to you.
Do you have to pay taxes on a car insurance settlement? Which parts of the settlement will you have to pay taxes on? Continue reading below to learn everything you need to know about auto insurance settlements and their taxability.
Digging Deeper Into Potential Taxation of Auto Accident Settlements
When considering the taxability of the compensation resulting from an auto accident settlement, the reason for the payment is of particular importance. Settlement dollars are applicable to:
- Lost wages
- Related medical costs
- Repairing damaged property
- Pain and suffering
- Emotional Distress
- Punitive damages to punish the negligent party
Are Lost Wages Taxable?
Wages you earn from your employer are taxable, so are lost wages also taxable? The answer is yes. Compensation stemming from the accident attributable to lost wages to replace what would have been earned if working is taxable. Financial compensation for future lost wages is also taxable. However, the taxation of lost wages is somewhat complicated as there is the potential to be taxed for multiple years of income for the year in which the settlement was received, possibly prompting a higher rate.
What About Damages Related to Property Damage and Medical Expenses?
If your vehicle is damaged in the accident, the portion of the settlement used to repair it is exempt from taxes. The same holds true for the payment you receive to repair any other property damage related to the accident.
The payment provided for medical treatment is also exempt from taxes. However, there is an exception. If a settlement is received for a personal physical injury or a personal physical illness, income must be included in the part of the settlement for medical expenses deducted in previous years up to the extent to which the deductions provided a benefit in terms of taxation. If a portion of the proceeds is attributable to medical expenses paid beyond one year, part of the proceeds are to be allocated on a pro-rata bases for the medical expenses for each year those medical expenses were paid.
The amount of money to be reported on taxes is shown in “Recoveries” in Publication 525. This tax benefit is to be reported in the form of “Other Income” on Form 1040’s line 21. It is important to note medical expenses can only be deducted up to the point that they exceed 10% of the adjusted gross income or if in excess of 7.5% if age 65 or older unless the medical expenses were deducted in a prior year.
What Else Is Taxable?
Payments received for pain and suffering, emotional distress, and other punitive damages will all be taxed by the IRS. There are, however, some exceptions.
If your pain and suffering settlement is related to a physical injury sustained in the accident, it won’t be taxed. If your pain and suffering is classified as emotional distress, however, it will be taxed.
Did You Use a Lawyer for Your Settlement?
If your lawsuit goes to court and you rely on an attorney for the subsequent settlement, you must pay taxes on the full amount you receive. This is in spite of the fact that attorneys work on a contingency basis in most personal injury cases. In other words, you might lose upwards of one-third of your personal injury settlement in the form of the contingency fee and also have to pay taxes on part of the settlement simply because of the attorney’s involvement. Furthermore, if a 1099 form is received from the defendant, it will be taxed as self-employed income. This means you’ll be responsible for the employer’s portion of Social Security as well as Medicare taxes.
To illustrate this, let’s say a lawyer helps you receive a $10,000 settlement.
- $3,333 will be used to pay for taxes
- $3,333 will be used to pay for the lawyer
- $3,333 you will be able to keep
There Are Ways to Decrease the Tax Obligation Stemming From Your Settlement
Your personal injury attorney will help you mitigate your tax obligation resulting from the settlement. As an example, one way to mitigate taxes is through a structured auto insurance settlement. This approach minimizes taxes while providing the settlement payout in the form of installments. Also referred to as a structured settlement, this settlement makes it possible to exclude income from current taxes.
Furthermore, the categories of damages also matter. There are two distinct types of damages available when suing another driver: special damages and general damages. General damages are comparably subjective, inclusive of pain and suffering. Special damages are comparably easy to quantify. This form of damages includes lost wages. Your attorney will help you determine which form of damages to pursue and the proper payout structure with tax mitigation in mind.
Why Doesn’t the IRS Pursue Taxes on Car Insurance Settlements?
Though the IRS sometimes pursues taxes on auto insurance settlements as detailed above, the tax collectors generally avoid doing so. Rather, the IRS typically levies taxes on an individual’s income. Income is considered a payment that increases wealth. Alternatively, settlements are meant to make the injured individual whole once again. Insurance settlement money is provided to bring the victim back to the state he or she was in prior to the accident. Therefore, even if you are provided with a considerable payout from the insurance company to repair your vehicle, the money will not be taxed if it is meant to make you whole once again.
What About Interest Earned on a Settlement?
If you earn interest on your settlement, you should know it is taxable. However, not all money paid through auto insurance settlements includes interest. The manner in which you bank and maintain the auto insurance settlement money determines if you earn interest on it. Consult with your tax advisor to identify the specific parts of tax forms that pertain to information about income earned through interest.
When in Doubt, Consult With an Expert on Auto Insurance Settlement Taxation
If you are uncertain as to whether your car insurance settlement is taxable, do the smart thing by reaching out to a tax professional for guidance. A certified public accountant or tax attorney knows exactly how to interpret the language of the Internal Revenue Code. Pose any questions or concerns you have to this individual.
If you anticipate your settlement will be particularly large, contact your attorney about whether you should consult with a tax professional prior to signing the final agreement. As an example, if you anticipate a payment for lost income for future years, there is a good chance settlement options are available to reduce your tax burden. When in doubt, reach out to your local IRS office for guidance.
Final Word – Are Car Insurance Settlements Taxable?
If you receive an auto insurance settlement, part of it may be taxable. The payments you receive to compensate you for medical bills will not be taxed. The payments you receive to repair your vehicle and other property also won’t be taxed.
Things that will be taxed include:
- Lost wages
- Pain and suffering
- Emotional Distress
- Other punitive damages
If you do receive a taxable settlement, you’ll receive a 1099 form to use come tax-filing time.
Please contact an accountant or a tax attorney for any additional questions you might have about the taxability of your auto insurance settlement.