Are car accident settlements taxable?
The IRS only taxes income, which is money you receive that makes you wealthier than before.
While Congress can tax any income, they generally only do so to the extent that this income caused your net worth to increase, according to Andrew Head, Certified Financial Planner and professor at Western Kentucky University.
Insurance is designed to make you whole after an accident, which brings you back to the same state you were in before the incident, not make you wealthier, which is why most insurance settlements are not taxable.
However, there can be instances where auto accident compensation is taxable. While the money to repair or replace your vehicle is usually not taxable, payments for pain and suffering or emotional distress may fall into the taxable category.
Here's a car accident settlement example broken down into categories:
- Replacement of your vehicle: $12,000
- Lost wages due to injury: $ 5,000
- Medical bills: $ 5,000
- Pain and suffering: $14,000
- Total settlement: $24,000
While much of this settlement would be tax-exempt, parts of it will require you to pay taxes.
In this case, the pain and suffering portion of the settlement are taxable. Lost wages are taxable because they replace your income, which would have been subject to income tax.
Below, we'll break it down in detail.
Car insurance settlement for repair or replacement of car or other property: Tax-exempt
You do not have to pay taxes on compensation to repair or replace your car. You are no better off financially after the claim than before, so this isn't considered income. Your insurer made you whole after your loss.
Using our example, if the insurance company determines your vehicle's value is $12,000, and it was totaled in an accident, it will write you a check for $12,000 minus your deductibleThe deductible is the amount you pay out of pocket for a covered loss when you file a claim., putting you back in the same financial place that you started before the accident. You have gained nothing financially (you are slightly less wealthy after paying the deductible), so this isn't taxable income.
Car insurance settlement for lost wages: Taxable
A serious car accident can result in serious injuries, and if you can't work due to your injuries, you may be compensated by your insurer. In most cases, you must pay taxes on this compensation because it will be considered income.
Compensation for lost wages is intended to replace what you would have earned had you not been injured. If you don't completely recover, you may also receive compensation for future lost wages.
Wages are always taxable, which means compensation for lost wages is also taxable. Unfortunately, taxation for lost wages can be tricky; depending on how your settlement is structured, you could end up paying a higher tax rate than you would typically pay.
Let’s look at a few scenarios to illustrate how your tax rate and total settlement amount can be impacted. In these examples, assume you earn $37,000 a year and are in a 15% tax bracket:
- Smaller settlement: If you receive a smaller settlement, like the $5,000 outlined in our example above, it shouldn’t impact your tax rate. It will be taxed as income but at your current rate of 15%.
However, since you are not an insurance company employee, they will issue a 1099 instead of a W-2, which means you're taxed as a self-employed person instead of an employee. Because of this, you will be responsible for the employer's part of Social Security and Medicare taxes. The tax rate for Medicare and Social Security will run about 15.3%.
- Large settlement: If you receive a large settlement representing several years of income all at once, you will most likely be taxed at a higher rate than you usually pay.
For example, at $37,000 a year, you'd be taxed at a 15% rate. However, if you receive three years of lost wages in your settlement -- you're now paying taxes on $111,000, which puts you in the 28% bracket. You'll also have to pay Social Security and Medicare taxes on the insurance settlement money.
- Settlement with a lawyer involved: If you had to get a lawyer involved (which is not uncommon), your piece of the pie would grow smaller while your tax bill got bigger.
Even though your lawyer (working on contingency) will take roughly one-third of your settlement, you will be responsible for taxes on the entire settlement amount and paying the Social Security and Medicare taxes.
In our example, your lost wages are $5,000, so you will be taxed at the 15% rate, plus 15.3% for Medicare and Social Security. Assuming that your attorney earns one-third of your entire settlement, the calculation looks like this:
| Lost wages settlement: | $5,000 |
| Less: | $1,650 attorney fees |
| Less: | $750 income tax on $5,000 (at 15% rate) |
| Less: | $765 Social Security and Medicare tax (at 15.5% rate) |
| Adjusted settlement: | $1,835 |
| Add tax savings: | $248 if itemizing attorney's fee expense |
| Net settlement amount: | $2,083 |
If you itemize deductions, you may be able to deduct the attorney's $1,650 from your income, saving you around $248 in taxes.
After paying your attorney and Uncle Sam, you should receive a net auto insurance settlement of $2,083--less than half the total amount.
Auto insurance settlement for medical bills: Tax-exempt
In most cases, auto insurance claims for medical bills are tax-exempt. The insurance company will usually pay the hospital directly or reimburse you for medical bills you have already paid, which would not be considered income.
For example, if you incurred $5,000 in medical bills after an auto accident, your personal injury protection (PIP) coverage would reimburse you for those expenses. Since the $5,000 payment is merely reimbursing you for the money you spent, it is not income and not taxable.
However, there can be exceptions, according to the IRS:
"If you receive a settlement for personal physical injuries or physical sickness, you must include in income that portion of the settlement that is for medical expenses you deducted in any prior year(s) to the extent the deduction(s) provided a tax benefit. 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.”
While this exception exists, it probably doesn't apply to many people. You can only deduct medical expenses exceeding 10% of your adjusted gross income. However, if you deducted your medical expenses in a previous tax year, you must pay taxes on those amounts for the year you receive your settlement.
Car insurance settlement for pain and suffering: Taxable in some cases
If your pain and suffering result from a physical injury, your award is not taxable. However, if your pain and suffering are classified as emotional distress, it is taxable, and you must pay taxes on the amount paid to your attorney.
If, for example, you developed a fear of driving as a result of an accident, compensation for your anxiety disorder would be taxable. However, compensation for emotional distress resulting from a physical injury is tax-exempt.
Reducing the tax owed on your car insurance settlement
There are ways to create a settlement with minimal or no tax obligation. A skilled tax lawyer should be able to assist you in one of two ways:
Structured auto insurance settlement
If your settlement is very large, perhaps covering many years of future lost wages, you can avoid some taxes by having your money paid out over an extended period. This is called a "structured settlement," which lets you exclude some of the income payout from current taxes.
The car insurance company must purchase an annuity for your benefit in an amount that will earn enough interest income to replace your lost wages. Every payment you get from this is part interest (non-taxable). The rest is money paid by the insurance company (taxable). You'd receive a Form 1099 from the insurance company each year. Typically, a structured settlement can save you between 25% and 35% of taxes on interest income that would otherwise be subject to tax.
Classifying damages in your car insurance settlement
There are two categories of damages when you sue another driver: general and special. How your settlement is classified will impact your tax obligation.
- Special damages are easy to quantify. Lost wages would be considered special damages, and lost wage compensation is always taxable because it is considered income.
- General damages are more subjective and include (non-taxable) pain and suffering. When structuring a settlement, it can be beneficial to push more of the settlement amount into these categories if possible, lowering your tax obligation.
When answering whether your personal injury settlement is taxable, it often makes sense to consult a tax attorney. Achieving a tax-friendly settlement is important during your negotiation with an insurer. In many cases, hiring a tax attorney to help with your negotiations is worth the cost, particularly if you are working on a large settlement.
Frequently asked questions about auto insurance settlements
Are car insurance settlements taxable in no-fault states?
In a no-fault state, some portion of a car insurance settlement may be taxable. For example, in Michigan, no-fault insuranceAn auto insurance system where medical expenses are covered by your insurer regardless of fault. Personal injury protection (PIP) and medical payments (MedPay) are no-fault insurance coverages. pays up to three years of lost wages.
"But, after the first three years, if that same person will still be disabled, then a claim for excess economic loss can be made against the person who caused the car accident. This second claim for lost wages will be taxable as an excess economic claim," says Steven Gursten, an attorney with Gursten, Koltonow, Gursten, Christensen & Raitt in Farmington Hills, Mich., specializing in auto insurance law.
Is interest earned on your car accident settlement taxable?
If you have received a large settlement, you may end up depositing some of the money in a bank account or mutual fund to earn interest on the money. In this case, you would have to include any interest earned on your tax return as it would be considered income, which is always taxable.
Are punitive damages in an insurance settlement taxable?
Punitive damages are damages assessed against the defendant to punish a defendant for negligence. In most cases, the defendant is a company or other large entity. An example of this kind of damage might involve a defect in your vehicle that ended up causing an accident or injury. Punitive damages are taxable because they do not compensate you for out-of-pocket losses. Essentially, they are income, so you must pay taxes on any punitive damages.
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