The Internal Revenue Service (IRS) has very clear rules about insurance settlements. While many settlements due to a car accident are not taxable, some are. There may be only a portion of a settlement that is taxable, too. If you are involved in a collision and receive a settlement, you really need to talk to an income tax advisor when you do your income taxes. It can be, well, complicated.
Insurance settlements that are not taxable
Settlements paid for damage to your vehicle and for pain and suffering due to physical injury are not taxable. The amount for damages can also include the cost of towing the car and the cost of a rental car so you can get around while your car is getting repaired.
Why a portion of an insurance settlement would be taxable
There are five reasons for a portion of a settlement to be taxed as income. They are, for the most part, pretty straightforward; however, there is an important “if” for one of them.
Settlement is for loss of income
Money you receive as compensation for loss of income is considered taxable by the IRS. You must report it as income in the year you received it and pay taxes on it. This could bump you up an income tax bracket or two, if you are being compensated for lost wages from more than one year.
For instance, if you couldn’t work for six months in one year and six months the next year before you get your settlement, the entire amount is considered taxable income in the year in which it is received.
Compensation is for medical bills
Settlement money received for medical expenses can be complicated. You must report any compensation you get for medical expense that you used as a tax deduction in previous years. In addition, the Internal Revenue Service says,“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.”
An income tax professional really should be consulted to make sure you report this properly.
Settlement is for punitive damages
If you do receive a settlement for punitive damages, it is also considered taxable income. This type of settlement is unlikely to occur, though, as it is very rare in car insurance settlement cases. It is extra money awarded to the plaintiff to punish the defendant for their reckless, irresponsible, or dangerous actions.
Settlement is for emotional distress
Any portion of a car insurance settlement that is awarded for emotional distress suffered by the plaintiff due to the car accident is considered taxable income. It must be reported to the IRS and you must pay income taxes on that amount.
You earned interest on the settlement amount
Any interest earned on the settlement amount after it is awarded to you is considered taxable. You must report it to the IRS and pay income taxes on it.
How your insurance settlement is taxed
The taxable portion of your insurance settlement is not taxed as ordinary income. It is taxed as self-employment income. This means you must pay an extra self-employment tax on the money. An IRS form 1099 will be issued to you by the defendant. You even have to pay taxes on the one-third of the settlement amount that is commonly paid directly to a personal injury lawyer as soon as the settlement is granted. That is, if you have a personal injury lawyer. Medicare tax and Social Security tax must also be paid on the portion of the settlement that is taxable.