Car accident insurance settlements are generally not taxable, although there are certain exceptions, according to the Internal Revenue Service (IRS).
"If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income," the IRS said.
However, there are instances where auto accident compensation is taxable. It depends on how your settlement is structured. The negotiation between you and the driver who injured you should include tax considerations so you can keep as much of your settlement as possible.
Is my car accident settlement taxable?
The taxability of compensation depends mostly on the reason for the payment -- to offset your lost wages, replace or repair your damaged property, cover your medical costs, recompense you for pain and suffering or to punish the wrong-doer.
An example settlement breakdown might look like this:
Lost wages $ 5,000
Medical bills $ 5,000
Pain and suffering $14,000
Total settlement: $24,000
Auto accident settlements: what's taxable and what isn't
How does settlement money get taxed? Some elements of a hypothetical settlement are taxable, including:
- Payments for lost wages or lost profits
- Interest on any award
- Most punitive damages (whether or not there is physical injury or illness is involved)
- Damages for emotional distress
Car insurance settlement for lost wages: taxable
Compensation for lost wages is intended to replace what you would have earned had you not been injured. If you don't make a complete recovery, you may also receive compensation for future lost wages. Why do you have to pay taxes on an insurance settlement for lost wages? Because wages are taxable. That means compensation for lost wages is also taxable.
Taxation for lost wages can be tricky. You could be taxed for several years of income in the year that you receive a settlement. This could cause you to be taxed at a higher rate than you normally pay. I
f you typically earn $37,000 a year, for instance, you'd be taxed at a 15% rate. Suppose, however, that you receive three years of lost wages in your settlement -- you're now paying taxes on $111,000, which puts you in the 28% bracket. You'll also have to pay Social Security and Medicare taxes on that insurance settlement money.
It can get worse if you have an attorney representing you, because you have to pay taxes on the entire settlement, even though an attorney on contingency typically receives one-third of your auto insurance settlement, right off the top. And you receive a 1099 from the defendant, not a W-2, as you would from your employer, which means you're taxed as a self-employed person. Being deemed as self-employed means you're responsible for the employer's part of Social Security and Medicare taxes.
In our example, lost wages are only $5,000, so you'd probably be taxed at the 15% rate, plus 15.3% for Medicare and Social Security. Assuming that your attorney earns one-third of your entire settlement, the calculation looks like this:
Lost wages settlement: $5,000
Less: $1,650 attorney fees
Less: $750 income tax on $5,000 (at the 15 percent rate)
Less: $765 Social Security and Medicare tax (at the 15.5 percent rate
Adjusted settlement: $1,835
Add tax savings: $ 248 if itemizing attorney's fee expense
Net settlement amount: $2,083
If you itemize deductions, you may be able to deduct the attorney's $1,650 from income, saving you $248 in taxes.
After paying your attorney and Uncle Sam, you should receive a net auto insurance settlement of $2,083--less than half the total amount.
Auto insurance settlement for medical bills: tax-exempt
Payment for medical treatment is tax-exempt, but there is an exception. The IRS says:
"If you receive a settlement for personal physical injuries or physical sickness, you must include in income that portion of the settlement that is for medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit. If part of the proceeds is for medical expenses you paid in more than one year, you must allocate on a pro rata basis the part of the proceeds for medical expenses to each of the years you paid medical expenses. See Recoveries in Publication 525 for details on how to calculate the amount to report. The tax benefit amount should be reported as 'Other Income' on line 21 of Form 1040."
Why are auto accident insurance proceeds taxable? To avoid "double dipping" at taxpayers' expense, this probably doesn't apply to many people, because you're only allowed to deduct medical expenses that exceed 10% of your adjusted gross income. However, if you deducted your medical expenses in a previous tax year, you must pay taxes on those amounts for the year in which you receive your settlement.
Car insurance settlement for pain and suffering: taxes vary
If your pain and suffering is the result of a physical injury, your award is not taxable. However, if your pain and suffering is classified as emotional distress, it is taxable, and you must pay taxes on the amount paid to your attorney.
If, for example, you were not injured in an auto accident, but you developed a fear of driving as a result, compensation for your anxiety disorder would be taxable. However, compensation for emotional distress resulting from a physical injury is tax-exempt.
Reducing your car insurance settlement tax obligation
There are ways to create a settlement with minimal or no tax obligation. A skilled trial lawyer should be able to assist you in one of two ways:
1. Structured auto insurance settlement
If your settlement is very large, perhaps covering many years of future lost wages, you can avoid some taxes by choosing to have your money paid out over an extended period. This is called a "structured settlement" and it lets you exclude some of the income payout from current taxes.
The car insurance company must purchase an annuity for your benefit in an amount that will earn enough interest income to replace your lost wages. Every payment you get from this is part interest (non-taxable). The rest is money paid by the insurance company (taxable). You'd receive a Form 1099 from the insurance company each year. Typically, a structured settlement can save you between 25% and 35% of taxes on interest income that would otherwise be subject to tax.
2. Classifying damages in your car insurance settlement
There are two categories of damages when you sue another driver -- general damages and special damages.
- Special damages are easy to quantify -- lost wages would be considered special damages.
- General damages are more subjective and include (non-taxable) pain and suffering.
Achieving a tax-friendly settlement is an important goal during your negotiation with an insurer.
Other tax considerations with auto insurance settlements
Taxation issues can get complicated if you live in a no-fault state, says Steven Gursten, an attorney with Gursten, Koltonow, Gursten, Christensen & Raitt in Farmington Hills, Mich., which specializes in auto-insurance law.
Under Michigan's no-fault insurance law, for example, people who are injured in a car accident first turn to their own insurance company. That insurance company is responsible for up to the first three years of lost wages. These lost wages are paid at 85% of what that person would have been making if they had not been injured and this part of the settlement is not taxable.
"But, after the first three years, if that same person will still be disabled, then a claim for excess economic loss can be made against the person who caused the car accident. This second claim for lost wages will be taxable as an excess economic claim," says Gursten.