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Are Car Insurance Settlements Taxable

One of the most common questions we get on insurance claims is, “do you pay taxes on insurance settlements?”

Unfortunately, there is not only one answer because car accident insurance settlements can have several different components, and some of those are taxable while others are tax exempt.

Knowing which parts of your settlement are taxable is always important, especially if you want to stay in good standing with the IRS. Keep reading to learn everything you need to know about auto insurance settlements and the IRS.

Is my car accident settlement taxable?

Here is an expert tip on how to determine whether a settlement is taxable or tax-exempt:  

The IRS only taxes income, which is money you received that makes you wealthier than you were before.

“While the 16th amendment gives Congress the "right to lay and collect taxes on incomes, from whatever source derived," Congress taxes accretions to wealth. In other words, while Congress can tax any income, no matter whether its cash or the value of chickens received as compensation, they generally only do so to the extent that this income actually caused your net worth to increase”, says Andrew Head, Certified Financial Planner and professor at Western Kentucky University.

Insurance is designed to “make you whole” after an incident, which brings you back to the same state (wealth wise) you were in before the incident, not make you wealthier, which is why most insurance settlements are not taxable.

However, there can be instances where auto accident compensation is taxable, but it depends on how your settlement is structured and what is included. While the money to repair or replace your vehicle is usually not taxable, items such as pain and suffering or emotional distress may fall into the taxable category.

Let’s use the following settlement example to see which parts of it may require you to pay taxes and which sections are tax-free:

  • Replacement of your vehicle: $12,000
  • Lost wages: $ 5,000
  • Medical bills: $ 5,000
  • Pain and suffering: $14,000
  • Total settlement: $24,000

Using our expert tip, see if you can guess which of those are taxable and tax-exempt.

While much of this settlement would be tax-exempt, there are parts of it that will require you to pay taxes. Let's break it down to see where tax issues may pop up (and see if your guesses were right).

Are Car Insurance Settlements Taxable

Car insurance settlement for repair or replacement of car or other property: Tax-exempt

This is one of the most common reasons you will receive money from an auto insurance claim. In most cases, it will be to repair or replace your vehicle after an accident, but it could also apply to vandalism or other damage done to your car.

Regardless of the reason, you do not have to pay taxes on this type of compensation. You are no better off financially after the claim than you were before it, so this cannot be considered income. Your insurer simply 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, they 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 (actually, you are slightly less wealthy after paying the deductible), so the IRS will leave you alone.

Car insurance settlement for lost wages: Taxable

A serious car accident can result in serious injuries, and if you are unable to work due to your injuries, you may be compensated by your insurer. In most cases, you will need to pay taxes on this compensation because it will be considered income.

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.

Wages are always taxable, which means compensation for lost wages is also taxable. Unfortunately, taxation for lost wages can be tricky; depending on how your settlement is structured, you could end 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, which puts you in the 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%.

However, since you are not an employee of the insurance company, they will issue a 1099 instead of a W-2, which means you're taxed as a self-employed person instead of an employee. Because of this, you will be responsible for the employer's part of Social Security and Medicare taxes. The tax rate for Medicare and Social Security will run about 15.3%.

  • Large settlement: If you receive a large settlement that represents several years of income all at once, you will most likely end up being 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 will grow smaller while your tax bill gets 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 in addition to 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 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.

Auto insurance settlement for medical bills: Tax-exempt

In most cases, auto insurance claims for medical bills are tax-exempt. When it comes to medical bills and auto insurance, the insurance company will usually pay the hospital directly or simply reimburse you for medical bills you have already paid, which would not be considered income.

As an 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.”

While this exception exists, it probably doesn't apply to many people. 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 you receive your settlement.

Car insurance settlement for pain and suffering taxable: 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 are 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 the tax owed on your car insurance settlement

There are ways to create a settlement with minimal or no tax obligation. A skilled tax lawyer should be able to assist you in one of two ways:

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.

Classifying damages in your car insurance settlement

There are two categories of damages when you sue another driver -- general damages and special damages and how your settlement is classified will impact your tax obligation.

  • Special damages are easy to quantify -- lost wages would be considered special damages, and lost wage compensation is always 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, which will lower your tax obligation.

When trying to answer the question, is your personal injury settlement taxable, it often makes sense to consult a tax attorney. Achieving a tax-friendly settlement is an important goal during your negotiation with an insurer. In many cases, it is worth the cost to hire a tax attorney to help with your negotiations, particularly if you are working on a large settlement.

Frequently asked questions about auto insurance settlements

Are car insurance settlements taxable in no-fault states?

“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.

Is interest earned on your car accident settlement 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, which is always taxable.

Are punitive damages in an insurance settlement taxable?

Punitive damages are damages assessed against the defendant to punish a defendant for negligence. In most cases, the defendant is a company or other large entity. An example of this kind of damage might involve a defect in your vehicle that ended up causing the accident or injury. Punitive damages are taxable because they are not compensating you for out-of-pocket losses. In essence, they are income, so you will have to pay taxes on any punitive damages.