Are Car Insurance Settlements Taxable?
Have you recently received a car insurance settlement or do you have one on the way? While they can provide financial assistance to assist you in recovering from an accident, you may be wondering if there is a catch. Are automobile insurance settlements taxable? Here's a closer look at what they are and how you can lower your tax bill.
Taxes Depend on the Type of Car Insurance Settlement
The types of damages involved determine whether or not you must pay taxes on your car insurance settlement. But what kinds of damages are there? The following are the main categories:
- Medical bills: Payments for reasonable and necessary medical costs (hospital stays, doctor visits, surgeries, rehabilitation, medications, and so on) incurred as a result of the accident.
- Pain and suffering: Compensation for the pain and suffering you endured as a result of an accident, including physical pain, humiliation, mental anguish, disfigurement, loss of quality of life, and more.
- Property damage: Payments to cover the cost of replacing property lost or damaged in an accident, most commonly vehicles.
- Income replacement: Replacement of wages lost as a result of the accident.
- Punitive damages: Damages assessed in excess of the amount required to punish a defendant for negligence.
Insurance is designed to compensate you for your losses, allowing you to rebuild your life after an incident. In some cases, however, your payments may provide you with a financial benefit. When the government determines that you have made a gain or profit, taxes are levied.
Assume your $15,000 car is totaled in an accident and you are awarded $14,500 ($15,000 less your $500 deductible) to cover the loss and replace the vehicle. The money you receive is not taxable. However, if you were to receive $14,500 in punitive damages, you would be taxed on that amount.
Taxable Car Insurance Settlements
So, what are the taxable insurance settlements? The following are the main types:
Emotional Distress
Settlements for emotional distress are taxable when the condition is not the result of a physical injury caused by the accident. For example, if you were rear-ended, broke your leg, and experienced increased anxiety as a result, you would not be taxed on your emotional distress payments. The emotional distress settlement, on the other hand, would be taxable if you were not physically injured in the accident but still experienced anxiety.
If your emotional distress settlement is taxable, you can deduct your emotional distress-related medical expenses. In other words, if you received a $10,000 settlement for emotional distress and paid $1,000 to treat it medically, you could deduct $1,000, lowering your taxable amount to $9,000.
Punitive Damages
Even if you receive a settlement for punitive damages as part of a physical injury case, the funds are taxable as part of your income. Punitive damages, which are considered punishment for the person or organization responsible for your injuries, may be awarded in cases of egregious misconduct.
Nontaxable Car Insurance Settlements
Next, let's look at the types of car insurance settlements that aren't typically taxable.
Lost Wages Due to Physical Injury
If you are in a car accident and miss work or lose your regular paycheck, a settlement can help you recover those lost wages. If you lost wages due to a personal physical injury, you can deduct them from your taxable income. You can also seek compensation for lost future earnings if you are no longer able to perform the same type of work you did before the accident.
Medical Bills
If you were injured in a car accident and received a settlement to cover your medical expenses, that amount is tax-free. The law exempts from taxation any settlements that provide compensation for physical injuries or illnesses (other than punitive damages).
Repair or Replacement of Property
If your car is damaged in an accident, the settlement to repair or replace it is not taxable as long as it does not exceed your adjusted basis in the car, which is typically the amount you paid for it plus the cost of any improvements you made. You can have your car repaired or replaced without worrying about the tax bill.
Pain and Suffering
If you receive compensation for pain and suffering as a result of a physical injury, that portion of your settlement will be exempt under the same law that exempts medical bills. These funds are intended to compensate you for your loss and return you to your pre-accident condition.
How To Reduce Your Taxes on Car Insurance Settlements
If you want to reduce your taxes on car insurance settlements, make sure all of your payments are properly classified. Keep detailed records of all receipts and payments for your injuries and/or property damage. Remember that an auto accident can injure more than just your car. Make a list of any property that needs to be replaced as a result of the accident, as well as its monetary value.
In addition, if you expect a large settlement from a physical injury, a structured settlement may be the most tax-efficient option. Structured settlements are paid out over time in the form of annuity payments and are completely tax-free.
Frequently Asked Questions (FAQs)
How do car insurance companies calculate settlements?
Settlements can be calculated in a variety of ways by car insurance companies. In Florida, for example, the law simply states that the calculation must be "fair and just in light of the evidence."
Another method is to multiply "special damages" by a multiplier that reflects the severity of "general damages." Then, add in lost wages to get the settlement amount. (Special damages are quantifiable losses, such as property damage and medical bills. They can be calculated with specific monetary values. General damages are losses that are more difficult to quantify, such as pain and suffering.)
Amount of special damages multiplied by the general damages multiplier + wages lost = Settlement amount. Then the settlement talks can begin.
Is interest earned on insurance settlements taxable?
If you earn interest on your insurance settlement, the IRS considers it interest income and it is taxable.