So you’ve just received a payout from your insurance company. Typically, when you receive a lot of money, you have to report it on your taxes. But are car insurance proceeds taxable? Do you have to report your car insurance proceeds on your tax return?
Today, we’re answering everything you need to know about the tax implications of a car insurance payout.
Car Accident Insurance Settlements Are Generally Not Taxable
Generally speaking, any money you receive from your insurance company to settle a car accident claim is not taxable.
You’re not required to pay taxes on compensation for your damaged vehicle, for example, nor are you required to pay taxes on compensation for medical expenses.
You should not include the settlement proceeds on your income.
However, there are some exceptions to this rule that you need to be aware of. In some situations, the IRS does consider car insurance proceeds to be taxable.
You Need to Pay Taxes on Compensation for Lost Wages
Typically, car insurance settlements are not taxable. The major exception to this rule is with settlements for lost wages.
If you’ve been injured in a car accident and are unable to work, then you may receive a settlement for lost wages. This money is intended to cover the amount of money you would have earned if you had been able to work.
If you don’t make a complete recovery from your car accident injuries, meanwhile, then you may also receive compensation for future lost wages.
Because wages are taxable, you’ll need to pay taxes on compensation for your lost wages.
Generally speaking, this tax burden is comparable to your ordinary taxes. If you pay $500 per month in taxes from your normal job where you make $20 per hour, for example, then you will pay $500 per month in taxes from your wage compensation.
Settlements and taxation can get tricky, however, with certain wage settlement cases. If you’re unable to work for three years, for example, then you might receive three times your annual income in a single settlement. This will bump you up to a higher tax bracket, which means you’ll effectively earn less money than you would in a normal year, simply because you received all the money at once.
Complicating matters further is that you might have an attorney who takes a chunk of that settlement. Typically, a car insurance attorney will take one-third of your settlement off the top. You’re still required to pay taxes on the full amount, however. In some cases, you may be able to deduct the attorney’s expenses from your income to lower your tax burden.
There’s one final annoying complication: the money you receive through your settlement is treated the same as self-employment income by the IRS. That means you need to pay Social Security and Medicare as both an employer and an employee.
Medical Expense Compensation is Non-Taxable
In virtually all situations, payment for medical treatment is tax-exempt. You do not have to pay taxes on money you receive through a car insurance settlement when that money is designed to cover medical expenses.
The only exception to this rule, according to the IRS, is this:
“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.”
You Don’t Typically Pay Taxes on Car Insurance Settlements for Pain and Suffering
If you’ve received compensation for pain and suffering through a car insurance settlement, then taxes can vary.
If your pain and suffering is caused by a physical injury, then the money you receive is not taxable.
If your pain and suffering in the result of emotional distress, however, then it is taxable and you’ll need to pay tax on that amount.
If you were in a serious car accident and you’re now afraid of driving, for example, then your pain and suffering compensation will be taxable. If you were injured in that car accident and can no longer drive because you’re blind in one eye, however, then the compensation is not taxable.
Structured Auto Insurance Settlements Can Reduce Your Tax Burden
Taking your insurance settlement as a lump sum can lead to serious tax implications.
That’s why some choose a structured auto insurance settlement. This can reduce your tax burden by spreading your “income” (from the settlement) over a period of many years.
You end up with more money in the long run, after tax, even though your before-tax amount of compensation is the same.
Ultimately, if you have a major settlement and are concerned about the tax implications, then consider contacting an accountant or auto insurance attorney in your area to help you navigate the incident.