Do you have to pay taxes on a settlement?
You will have to pay taxes on any settlement amount for emotional distress and lost wages (when not related to a physical injury) and on punitive damages. However, you won't have to pay taxes on any portion of the settlement that directly reimburses you for financial loss or for pain and suffering related to physical injuries.
“Whether settlements are subject to taxation depends on the cause of the settlement and to what extent the settlement covers lost wages and compensation,” says Alex Durante, senior economist at The Tax Foundation, a nonpartisan tax policy nonprofit think tank.
Settlements to pay for property replacement and medical bills are typically not taxed since the money simply replaces money you’ve already spent. However, settlements for most types of lost wages, punitive damages, and some forms of pain and suffering (those not related to physical injury) are taxed.
For example, lost wages are taxable if not directly related to a physical injury, since you would be paying taxes on your wages regardless of the accident. While the tax rates are usually similar, you could pay much more if you receive a large lump sum to cover lost wages for an extended period, because it puts you in a higher tax bracket.
“Damages that are paid to compensate for lost income [directly related to a physical injury] would not be subject to any income taxation. However, punitive damages that are paid in such a settlement would be subject to tax,” Durante says.
Settlements for pain and suffering are a little trickier. You don't have to pay taxes if your settlement is for physical pain and suffering. However, you will pay taxes if your settlement is for emotional distress that isn’t the direct result of a bodily injury, such as anxiety after an accident in which you were not injured.
How to avoid paying taxes on settlement money
After an accident, the last thing you want is to have to share your settlement with the IRS. Fortunately, there are ways to lower your tax liability, such as allocating the settlement, taking a structured settlement, and working with a tax professional.
What types of settlements are tax-free?
It’s important to understand what types of settlements are taxed so that you can save as much of your settlement as possible.
“In general, punitive damages are subject to income taxation, except in wrongful death settlements,” Durante says.
However, these two main types of settlements aren’t taxed:
- Settlements to repair or replace vehicles or property aren’t taxed. The purpose of insurance is to return your property to its pre-accident condition. You aren’t gaining financially, so there is no income to tax.
- Settlements for medical bills are also not taxed. The insurer usually pays the hospital directly or reimburses you for bills you’ve already paid. Again, there is no income, only paying for medical bills due to the accident.
Avoid taxes by structuring the settlement
You can receive your settlement in one lump sum or a structured settlement. How you choose to accept it can affect your tax liability.
A structured settlement spreads out the money you receive over time. The settlement goes to a reputable life insurance company, which will pay you monthly. Depending on your settlement and needs, you can receive payments for years or possibly the rest of your life.
Receiving your settlement as a lump sum may move you to a higher tax bracket, increasing the amount of tax you'll need to pay on the taxable portions of the settlement, while spreading out the payments keeps you in a lower tax bracket, resulting in lower taxes.
Properly allocate the settlement
The way you allocate your settlement makes a significant difference in the amount of taxes you have to pay. You can reduce your tax liability by itemizing the settlement since some claims are tax-exempt.
For example, if you receive a $100,000 settlement without itemizing what the money is for, you may have to pay taxes on the entire amount. However, if $20,000 is for medical bills and $40,000 is to replace your vehicle, and the remaining $40,000 is for lost wages not related to an injury, you'll pay taxes on that last $40,000.
Additionally, properly allocating your attorney fees can save you significantly on taxes. If allocated properly, attorney fees related to taxable portions of the settlement may be tax-deductible, lowering your liability. However, tax laws have changed in recent years, so consult a tax professional before you file.
Use tax-deferred or protected accounts
Another way to limit tax liability is to put your settlement into tax-deferred or protected accounts. You can contribute settlement money to an IRA account, but it must be considered earned income and is subject to the same rules and limitations as any other contribution. An IRA contribution can reduce your tax liability.
Note that there are limits to how much you can contribute in a single year, so a larger settlement may not be fully tax-deferred using this method.
Get professional advice
Seeking advice from a tax professional before receiving a settlement can provide peace of mind, ensuring you have the smallest tax liability possible. The tax code can be complex, especially when dealing with a large insurance settlement, so working with a professional can help you avoid paying unnecessary taxes.
How to minimize taxes on a lump sum payment
If you're expecting a settlement, speak with a tax professional before you accept it. An expert can walk you through the process and help you avoid tax pitfalls, ensuring you get the most money out of your settlement.
For a particularly large settlement, consider speaking with a financial advisor as well. Professional help is the best way to properly structure your settlement and file your taxes properly.
Helpful auto insurance tools and calculators
