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Have you recently received a car insurance settlement or do you have one on the way? While they can provide financial relief to help you recover after an accident, you might be wondering if there’s a catch. Are car insurance settlements taxable? Here’s a closer look at which types are and how you can reduce your tax liability.
Whether or not you have to pay taxes on your car insurance settlement depends on the types of damages involved. But what types of damages exist? Here are the main categories:
Insurance is meant to indemnify your losses, helping you to become whole again after an incident. However, in some cases, your payments may provide you with a financial gain. Taxes come into play when the government deems you are receiving a gain or profit.
For example, say your $15,000 car is totaled in an accident and you receive $14,500 ($15,000 less your $500 deductible) to cover the loss and replace the car. The amount you receive would not be taxable. However, if you were to receive $14,500 in punitive damages, that payment would be taxable.
So, what insurance settlements are taxable? Here are the main types:
Settlements that pay for damages related to emotional distress are taxable when the condition does not stem from a physical injury caused by the accident. For example, if you were rear-ended, broke your leg, and experienced increased anxiety as a result, your emotional distress payments would not be subject to tax. However, if you were not physically injured in the accident but still experienced anxiety, the emotional distress settlement would be taxable.
If your emotional distress settlement is taxable, you can deduct your medical expenses that resulted from the emotional distress. In other words, if you received a $10,000 settlement for emotional distress and paid $1,000 to medically treat that distress, you could deduct it so that your taxable amount would be $9,000.
If you receive a settlement for punitive damages, the funds are taxable as part of your income, even if they are received as part of a physical injury case. Punitive damages may be awarded in the case of egregious misconduct and are considered punishment to the person or organization responsible for your injuries.
One exception is if punitive damages were awarded for wrongful death in a state where only punitive damages are provided for wrongful death claims.
Next, let’s take a look at the types of car insurance settlements that typically aren’t taxable.
If you are involved in a car accident that causes you to miss work and lose your normal paycheck, a settlement can help you recover those lost wages. If wages were lost on account of a personal physical injury, you can exclude them from your taxable income. You can also claim lost future income if you are no longer able to perform the same type of work as before the accident.
Lost wages may be subject to taxation if not on account of personal physical injury.
If you were physically injured in a car accident and received a settlement to cover the medical expenses, that amount is exempt from taxes. The law provides tax exemptions to any settlements that provide compensation for physical injuries or physical illnesses (other than punitive damages).
If you received a tax deduction on a prior year’s tax return for medical expenses related to the injury, that portion of the settlement would be taxable.
If your vehicle is damaged in an accident, the settlement to repair or replace it will not be taxable as long as it doesn’t exceed your adjusted basis in the car, which is generally how much you paid for it and the cost of any improvements you made. You can get your car repaired or replaced and don’t have to worry about the tax bill.
If you receive pain and suffering compensation that is linked to a physical injury, that part of your settlement will be exempt under the same law that exempts medical bills. These funds are meant to help compensate for your loss and return you to your pre-accident state.
If you’d like to minimize your taxes on car insurance settlements, it’s important to ensure all of your payments are properly categorized. Keep good records of receipts and payments for everything related to your injuries and/or property damage. Remember, more than just your car can be injured in an auto accident. Make note of any property you need to or have replaced on account of the accident and its value.
Also, if you’re expecting a sizable settlement from a physical injury, a structured settlement may be your most tax-friendly option. Structured settlements pay out over a period of years, via annuity payments, and are entirely excluded from your taxable income.
Car insurance companies can calculate settlements in different ways. For example, in Florida, the law simply says the calculation must be “fair and just in light of the evidence.”
Another approach is to multiply “special damages” by a multiplier reflecting the severity of the “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 using specific dollar amounts. General damages are losses that are harder to quantify like pain and suffering.)
Amount of special damages x General damages multiplier + Lost wages = Settlement amount
If you earn interest on your insurance settlement, it is considered interest income by the IRS so would be taxable.
