Are Auto Insurance Settlements Taxable Income?

If you’ve received a settlement from your auto accident, there’s a chance that you’ll have to pay taxes on it. It depends on what specific losses your settlement was for.

What is an auto insurance accident settlement?

An auto insurance settlement is money paid by the at-fault driver’s insurance company to the other driver’s insurance company in order to settle the claim for the car accident. The settlement amount depends on several factors, including the severity of the injuries and whether both drivers shared fault for the accident.

IRS Publication 4345 provides more information about the taxability of personal injury settlements. It’s also a good idea to discuss your specific situation with a personal injury lawyer and tax professional.

Do you have to agree with a settlement?

You have the right to refuse an insurance accident. It’s a good idea to get a car accident attorney to help you to figure out what you’re legally entitled to receive. A tax accountant can also help you figure out if the settlement structure will result in you paying more or less in taxes.

Are car accident settlements taxable?

Taxable income is money you receive that increases your net worth. If you are receiving a settlement as part of an auto accident claim, different parts of the money you receive will cover different things. Some of those things will be taxable, and others won’t be.

Are payments for property damage taxable?

Property damage includes repairing or replacing your vehicle. Since you only get enough money to restore your vehicle to the same condition or get an equivalent replacement, this portion of your settlement doesn’t increase your net worth. It isn’t considered taxable income.

 Are payments for lost wages taxable?

If you’re unable to work due to your car accident injuries, you’re entitled to be compensated for your lost wages. This includes the time you already missed from work, as well as if your future earning potential is now lower because of your injuries.

Wages are always taxable, so your settlement for lost wages will also be taxable. You’ll have to pay income taxes, Social Security tax, and Medicare tax, just like you would have if the payment came from your employer as a paycheck. In addition, you’ll also have to pay the employer’s share of your Social Security and Medicare taxes from your settlement amount. So you’ll pay 15.3% in FICA taxes plus your income tax rate.

Large settlements represent several years of income all in one lump sum. This means you’ll pay more in taxes than usual because you’ll be in a higher tax bracket in the year you receive the settlement. 

Are payments for medical bills taxable?

Payments for medical bills are tax-exempt in auto insurance settlements. This is because these payments are not considered income. You haven’t gained anything — you’re just back in the same financial position you would have been in if the accident didn’t force you to incur those medical bills.

One thing to note is that if you took a deduction for medical expenses you paid out of pocket and got reimbursed later, you may need to include that amount in your taxable income. For example, if you paid $10,000 in 2021 and took a deduction then got a settlement in 2022, you’d need to include $10,000 of the medical expenses portion of your settlement as income. The reason for this is to cancel out the deduction you took for expenses you didn’t actually pay in the end.

Are PIP payments taxable?

The tax status of PIP payments depends on what they were for. Most PIP payments are for medical expenses and are not taxable income. If your PIP protection includes lost earnings, the portion you received to cover lost wages is taxable.

Are pain and suffering payments taxable?

Whether pain and suffering payments are taxable depends on what they were for. They are generally not taxable when the pain and suffering is the result of a physical injury. However, payments for emotional distress or mental health issues, such as fear of driving, are generally taxable.

There isn’t really a good logical explanation for this other than that this is how the tax laws are written. See Internal Revenue Code Section 104 and Treasury Regulation 1.104-1.

Are punitive damages in an auto insurance settlement taxable?

Punitive damages are damages assessed by a court against a person who was negligent. The purpose of punitive damages is to punish the defendant for wrongdoing. Punitive damages are generally only awarded in particularly egregious cases.

Punitive damages are taxable. The reason is that they’re not compensating you for expenses you had or money that you lost. Instead, they are designed to deter future misconduct by other drivers. While you may prefer to have never been in an accident, punitive damages technically put you in a better financial position than you were in before.

How can you reduce the tax you owe on an auto insurance settlement?

While the defendant and their insurance company can’t change the tax law, they can agree to different terms of a settlement. The primary ways to reduce your taxes are to spread the payments out over time and to change what they’re for.

How should you classify damages in a car insurance settlement?

It’s to your benefit to get as much money as possible classified as not taxable. For the most part, it doesn’t affect the defendant if the payments are classified as medical bills or lost wages.

Of course, classifying your damages incorrectly would be considered tax fraud. However, the reason for auto insurance settlements is that damages aren’t always certain. If you think the most you can get at trial is $500,000 and you’re willing to settle for $400,000, you might get there by agreeing to lower compensation for lost wages instead of decreasing your medical expenses.

If there are any questions about the taxability of an item, the IRS will look at the exact wording of the settlement agreement to determine if it was intended to be taxed or not. Your attorney needs to carefully review all of these provisions before you sign them.

How can you structure an auto insurance settlement for lower taxes?

Auto insurance settlements are taxed based on the normal tax brackets. If you get a one-time payment of $500,000 that’s all taxable, you’ll pay the highest tax rate. If you split that into ten annual payments of $50,000, you’ll stay in a middle tax bracket unless your other income is very high.

A common way to structure a settlement is to get the non-taxable money, such as medical bills, immediately, then spread out the taxable money, such as lost wages. This works especially well when part of your claim includes loss of future earnings.

Can you deduct your auto insurance premiums or deductible?

You can’t deduct your insurance premiums from a taxable insurance settlement. You also can’t deduct your deductible. However, if you’re suing the other driver, part of your lawsuit includes covering your deductible.

Are attorneys’ fees deductible from your settlement?

You pay taxes on the full amount of your settlement before attorneys’ fees. If the taxable portion of your settlement is $300,000 and your attorney gets 1/3, you pay taxes on $300,000, not $200,000.

This is another reason to try to make your settlement payments not taxable whenever possible.

Conclusion

The tax status of an auto insurance settlement depends on what you’re being compensated for. If you haven’t signed a settlement yet, there are steps you can take to reduce your taxes. This is a complex area, and you should consult with both an auto accident lawyer and tax professional before making any decisions.

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