If you’ve recently received a settlement for a car accident insurance claim, you might be wondering if you have to report it to Uncle Sam. The answer is usually not, but it’s not always quite that simple. Insurance settlements are usually broken down into several categories: personal injuries or illness, pain and suffering, lost wages, property value, interest, and punitive damages. Several of the categories have their own taxation exceptions.
Settlements for lost wages are taxable. When an insurance settlement is meant to compensate you for lost wages, it should replace any income you would have received had you not been out of work because of injury or mental distress. In some cases, you might even receive a settlement to compensate for future lost wages if you aren’t expected to make a full recovery. Because your wages are taxable, compensation for them is also taxable.
Injuries and illness
Settlements you receive to cover medical treatments are mostly tax-exempt, but there is one exception. If you took an itemized deduction for any of those expenses to help lower your taxes, then that portion will be taxable. In other words, the IRS does not allow you to reap the benefits of that money twice.
Pain and suffering
Pain and suffering can be physical pain or emotional trauma, such as fear, depression and anxiety. This is an area that is also subject to some taxation exceptions. If you receive a settlement for pain and suffering as the result of an injury, that money is not considered taxable. However, if your physician labels your suffering as “emotional distress,” that amount is taxable. For example, if you developed PTSD as a result of the accident that you were not injured in, any amount you were awarded would usually be considered taxable. The pain and suffering must be directly linked to a physical injury to be tax-exempt.
In settlements you receive for property damage, the amount will be for the loss in value for that property. If the appraised value of your property exceeds the amount you received, it is not taxable. However, if the amount you receive is more than the property is worth, the amount above the value is considered a gain and is taxable. For example, if you get an estimate from your local car dealership that states your car was worth $22,000, but you received $25,000 from the settlement for property damage, $3,000 of that is considered taxable income.
Punitive damages are “monetary compensation awarded to an injured party that goes beyond that which is necessary to compensate the individual for losses and that is intended to punish the wrongdoer.” Because punitive damages are above what the courts deemed you were eligible to receive to cover expenses, that amount is always taxable.
If you receive any interest payments on your settlement, they are taxable under “interest income” on your tax form. One way you might receive interest on an insurance settlement is if you set up a structured settlement in the form of an annuity. Your car accident lawyer in Irvine will help you decide whether this is an option for your particular situation. If you do go this route, your annuity will accumulate interest. You will receive a 1099 from your annuity company each year reflecting the interest you’ve earned. You will then have to report that to the IRS as income.
A tax settlement in your favor is a big win, but make sure you talk to your CPA or tax adviser before spending any of it. If you know ahead of time what portion, if any, of the cash you receive is taxable, you can set that amount aside to take care of your debt.