Do you pay taxes on a car insurance settlement?
Car insurance settlements are not taxable in most cases. The IRS only taxes payments that are considered income and leave you in a better financial position than before the accident. Taxable portions of an accident settlement are punitive damages and payments for emotional distress and lost wages that are not the result of a physical injury.
While Congress can tax any income, they generally only do so to the extent that this income caused your net worth to increase, according to Andrew Head, Certified Financial Planner and professor at Western Kentucky University.
Insurance is designed to make you whole after an accident, which brings you back to the same state you were in before the incident, not make you wealthier, which is why most insurance settlements are not taxable.
You will not be taxed on payments for property damage, medical bills or payments directly related to a physical injury, including pain and suffering and lost wages. However, you will be taxed on payments for non-injury related distress and punitive damages.
Here's an example of a car accident settlement broken down into categories. In this case, only the $15,000 awarded as punitive damages is taxable. The lost wages, because the loss was due to an injury, are not taxable, and the remaining amounts restore you to your pre-accident position.
- Replacement of your vehicle: $12,000
- Lost wages due to injury: $5,000
- Medical bills: $5,000
- Punitive damages: $15,000
- Total settlement: $25,000
When is a car insurance settlement taxable?
A car insurance settlement is taxable when it leaves you better off financially than you were before the accident. That means you received a settlement that did more than pay the medical bills and repair your car. The IRS considers these amounts to be income and, therefore, taxable.
Here's a breakdown of the portions of a settlement that are taxable.
Car insurance settlement for lost wages: Taxable unless directly related to physical injury
A serious car accident can result in serious injuries, and if you can't work due to your injuries, you may be compensated by your insurer. If your compensation for lost wages is directly related to an accident injury, this amount may not be taxable. However, compensation for other lost wages, such as time off for emotional distress not related to an injury or to be in court, is taxable.
Compensation for lost wages is intended to replace what you would have earned had you not been injured. If you don't completely recover, you may also receive compensation for future lost wages.
Wages are income and therefore taxable, so compensation for lost wages is generally taxable as well. Furthermore, because settlements for lost wages are not from an employer, they are taxed via 1099 rather than W-2, which means you will have to pay Social Security and Medicare taxes as well. The tax rate for Medicare and Social Security is 15.3%.
Unfortunately, taxation for lost wages can be tricky; depending on how your settlement is structured, you could end up paying a higher tax rate than you would typically pay.
Let’s look at a few scenarios to illustrate how your tax rate and total settlement amount can be impacted. In these examples, assume you earn $37,000 a year and are in a 15% tax bracket:
- Smaller settlement: If you receive a smaller settlement, like the $5,000 outlined in our example above, it shouldn’t impact your tax rate. It will be taxed as income but at your current rate of 15%.
- Large settlement: If you receive a large settlement representing several years of income all at once, you will most likely be taxed at a higher rate than you usually pay.
For example, at $37,000 a year, you'd be taxed at a 15% rate. However, if 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 the insurance settlement money.
- Settlement with a lawyer involved: If you had to get a lawyer involved (which is not uncommon), your piece of the pie would grow smaller while your tax bill got bigger.
Even though your lawyer (working on contingency) will take roughly one-third of your settlement, you will be responsible for taxes on the entire settlement amount and paying the Social Security and Medicare taxes.
In our example, your lost wages are $5,000, so you will 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 15% rate) |
| Less: | $765 Social Security and Medicare tax (at 15.5% 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 your income, saving you around $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.
Car insurance settlement for pain and suffering: Taxable in some cases
Pain and suffering settlements are taxable when not related to a physical injury. So, if you are awarded a settlement for emotional distress stemming from the stress of the car accident and not from an injury, that portion of the settlement is taxable.
Car insurance settlement punitive damages: Always taxable
Punitive damages awarded in a car insurance settlement are always taxable. This type of settlement is meant to punish the person responsible, like a fine that is paid to you, and is considered income.
A settlement for punitive damages doesn't compensate you for any financial loss, therefore you will have to report it as income.
When is a car insurance settlement not taxable?
A car insurance settlement is not taxable when it reimburses you for financial loss due to the accident. Non-taxable portions of a settlement include property damage (repairs or replacement of your car or other property), medical bills, lost wages due to physical injury and pain and suffering payments due to physical injury.
Car insurance settlement for repair or replacement of car or other property: Tax-exempt
You do not have to pay taxes on compensation to repair or replace your car. You are no better off financially after the claim than before, so this isn't considered income. Your insurer made you whole after your loss.
Using our example, if the insurance company determines your vehicle's value is $12,000, and it was totaled in an accident, it will write you a check for $12,000 minus your deductible, putting you back in the same financial place that you started before the accident. You have gained nothing financially (you are slightly less wealthy after paying the deductibleThe deductible is the amount you pay out of pocket for a covered loss when you file a claim.), so this isn't taxable income.
Auto insurance settlement for medical bills: Tax-exempt
In most cases, auto insurance claims for medical bills are tax-exempt. The insurance company will usually pay the hospital directly or reimburse you for medical bills you have already paid, which would not be considered income.
For example, if you incurred $5,000 in medical bills after an auto accident, your personal injury protection (PIP) coverage would reimburse you for those expenses. Since the $5,000 payment is merely reimbursing you for the money you spent, it is not income and not taxable.
However, there can be exceptions, according to the IRS:
"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.”
In plain terms, if you previously deducted accident-related medical expenses on a prior tax return and then received a settlement that reimbursed those same expenses, you must report that amount as income in the year you received the settlement. This prevents you from receiving a deduction for the expenses and then receiving tax-free reimbursement for them.
While this exception exists, it probably doesn't apply to many people. You can only deduct medical expenses exceeding 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 you receive your settlement.
What tax forms will you receive for a taxable car insurance settlement?
You will receive a 1099-MISC tax form for any settlement amount that is taxable. The 1099 reports income from sources other than an employer.
Report this income on the "Other Income" section of your tax return, found on Schedule 1 (Form 1040) on your tax return. If you have questions about reporting settlement income, speak with a tax expert.
How to avoid paying taxes on settlement money
There are two strategies that can reduce your tax liability on a settlement: a structured settlement that spreads out payments over time to avoid being pushed into a higher tax bracket, and strategic damage classification, which shifts more of the settlement into non-taxable general damages such as pain and suffering due to physical injury. A tax attorney can help you choose an approach and implement it.
Structured auto insurance settlement
A structured settlement pays out your settlement over time rather than a lump sum payment that could push you into a higher tax bracket and cause you to pay more in taxes on the settlement. Structured settlements are best when you have received a large, taxable settlement amount. Typically, a structured settlement can save you between 25% and 35% of taxes on interest income that would otherwise be subject to tax.
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.
Classifying damages in your car insurance settlement
When negotiating a car insurance settlement, classifying more of the payout as general damages, such as pain and suffering due to physical injury (not taxable), rather than special damages like lost wages (taxable). Work with an attorney throughout the settlement process to ensure your damages are classified to your best advantage.
- Special damages are easy to quantify. Lost wages would be considered special damages, and lost wage compensation is generally taxable because it is considered income.
- General damages are more subjective and include (non-taxable) pain and suffering. When structuring a settlement, it can be beneficial to push more of the settlement amount into these categories if possible, lowering your tax obligation.
FAQ: Auto insurance settlements
Are car insurance settlements taxable in no-fault states?
Yes, in a no-fault state, some portion of a car insurance settlement is taxable. For example, in Michigan, no-fault insuranceAn auto insurance system where medical expenses are covered by your insurer regardless of fault. Personal injury protection (PIP) and medical payments (MedPay) are no-fault insurance coverages. pays up to three years of lost wages. This payment will be taxed under IRS rules that treat most lost wages as income.
"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 Steven Gursten, an attorney with Gursten, Koltonow, Gursten, Christensen & Raitt in Farmington Hills, Mich., specializing in auto insurance law.
Is interest earned on your car accident settlement taxable?
Yes, interest on a settlement is taxable. If you have received a large settlement, you may end up depositing some of the money in a bank account or mutual fund to earn interest on the money. In this case, you would have to include any interest earned on your tax return, as it would be considered income and therefore taxable.
Are punitive damages in an insurance settlement taxable?
Yes. Punitive damages are taxable because they do not compensate you for out-of-pocket losses and are considered income.
Is an insurance payment on a totaled car taxable?
No. An auto insurance claim settlement that pays to replace your car and doesn't leave you better off than you were before is not taxable.
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