Do You Have To Pay Taxes On Insurance Settlements?
How much would you have to pay in taxes?
What’s important to know?
Keep reading as we have gathered exactly the information that you need!
Let me explain to you if you have to pay taxes on insurance settlements!
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Let’s get started!
Do You Have To Pay Taxes On Insurance Settlements
It’s easy to get caught up in the excitement of a lawsuit settlement and forget about a key element of the process…paying taxes.
Oftentimes, successful plaintiffs get surprised when they get hit with a 1099 form in the mail and don’t know what to do.
For this reason, doing some tax planning in advance (even before you settle) goes a long way.
This holds true especially given the hefty lawyer fees that can go as high as 40% of the agreed settlement amount.
To help understand your situation better and get an idea of whether you’ll have to pay taxes on your settlement or not, read on!
Insurance Settlements
Generally speaking, money received as part of a settlement or insurance claim is not taxable.
The IRS imposes taxes on income (which is considered money that increases your wealth).
Insurance exists to put you in the same position you were in before, had you not experienced the accident or incident.
This means that if you receive money to fix damage caused by an accident, you won’t end up having more wealth than before, therefore not constituting income.
That said, there are some exceptions and general guidelines to be aware of…
Whether you received a settlement from an insurance company (out-of-court) or money after going through a trial that was ruled in your favor, the same tax rules apply.
Both are treated the same in the eyes of the Internal Revenue Service (IRS).
To determine whether your money is taxable, it’s useful to think about the origin of the payment.
For example, if you sue for getting laid off at work and want to be compensated, you’ll be taxed on those wages.
Whereas if you sue for damage to your building by a negligent contractor, then the damages won’t constitute income.
Applicable Rule
To get the full picture, we must look at the Internal Revenue Service (IRS) rules on the taxability of settlements and judgments:
“The applicable language of the Internal Revenue Service (IRS) regulation addressing the question of taxability of settlements and judgments is found at 26 C.F.R section 1.104-1(c): Damages received on account of personal physical injuries or physical sickness—(1) In general. Section 104(a)(2) excludes from gross income the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. Emotional distress is not considered a physical injury or physical sickness. However, damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2). Section 104(a)(2) also excludes damages not in excess of the amount paid for medical care (described in section 213(d)(1)(A) or (B)) for emotional distress.”
The above can be difficult to dissect, so we put it in layman’s language…
Insurance Settlement Examples
Repair Claims
Say you experience damage to your car following an accident, and you are awarded money for repair to the vehicle, this money is not taxable.
The money received from the insurance claim exists to put you in the same position before the car accident, so it doesn’t count as income.
Essentially, you’re not gaining anything, but simply reverting to your initial position.
For example, say your car accident damaged your passenger door, and it costs $5,000 to repair.
Your insurer awards you exactly $5,000 to fix the door.
In this situation, you haven’t gained any profits, and are in the same position had you not been in the accident, so the IRS won’t tax you.
An exception to this rule is if you had any ‘extra’ money after the repair, which could happen if the insurance company overpaid you or if you decided to repair the door yourself.
In any case, you’ll receive a 1099 form to file the taxes.
The same ruling applies to a home incident.
Say you hired an electrician who was negligent and their work caused a fire in your home.
If the insurance company compensates you to outsource the repair, this won’t count as income, and you won’t be taxed.
Medical Claims or Injury Compensation
When you receive money for compensatory damages to help support your medical expenses and take care of any physical injuries, the payment is typically not taxable.
Say you receive money to cover your medical expenses following an accident, or you get reimbursed directly from the insurance company after paying out of pocket for the medical appointments, you don’t have to pay taxes.
Most commonly, health insurance claims involve the insurance company sending the payments directly to the clinic or health provider, so you don’t need to worry in this situation.
An exception to the above rule applies during….
Related article:
Car Accidents
First off, any car accident settlements meant to compensate for personal injuries or pain and suffering are not taxable.
There are a couple of exceptions.
Money awarded for emotional distress caused by the car accident is treated as taxable income.
You must report the amount to the IRS and pay taxes on the total.
Also, if you earned interest on a settlement amount you received for a car accident, you must report the amount and pay the appropriate taxes.
Related article:
Life and Disability Insurance
If you receive a life insurance payout, this isn’t typically taxed as income.
Although there may be applicable estate taxes based on the insured estate’s size.
There may also be estate or inheritance tax based on the state of where the insured and beneficiaries reside.
On the other hand, say that you receive a life insurance payout, or withdraw money while the insured person is alive, this amount is considered taxable income.
Disability insurance payouts are also taxed as income since their purpose is to provide you with an income similar to what you would have received if you were able to work.
Lawsuit Proceeds
If an insurance claim has escalated to a lawsuit, there are some complications and exceptions to be aware of.
Compensation for medical bills and repairs are not taxed, but some payouts are, including:
- Punitive damages
- Lost income compensation
- Pain and suffering (exception: if it is caused by a physical injury)
- Emotional distress
Related article:
Lost Income Compensation
Money awarded for lost income or wages is taxable.
As discussed earlier, the wealth reasoning applies here, whereby any compensation intended to increase your wealth is subject to taxes (unlike compensatory payments).
For example, let’s say you couldn’t work for 5 months and received a lost income compensation payment for all months, you need to file with the IRS and pay the taxes the year in which you receive the payment.
Punitive Damages
Punitive damages are meant to ‘punish’ the defendant for their actions, and discourage future bad behavior and actions.
Although they aren’t common, and usually are awarded in outrageous and reckless circumstances, it’s important to know that they are taxable.
A tragic example would be a case where negligence resulted in the severe injury or death of a person or family.
For example, if an employee working at a rollercoaster station failed to properly secure a passenger, and ended up getting severely injured or even decapitated, their family may receive taxable punitive damages compensation.
Related article:
How Are Insurance Settlement Taxed
Say you’ve established that your settlement is taxable, now the next step is figuring out the details of how it’ll be taxed.
Generally, insurance settlements are taxed as self-employment income.
The IRS form 1099 will be issued to the plaintiff by the defendant.
If you paid a portion of your payout to a personal injury lawyer, you also need to file taxes on this amount.
Related article:
Takeaways
So there you have it folks!
The above guidelines can help you anticipate whether you’ll need to pay taxes on your insurance settlements or not.
Make sure to consult a lawyer and/or accountant to get a complete answer on the details of your particular settlement.
The content of this blog is for general information only and should not be relied upon to make important financial decisions, so be sure to consult a qualified legal professional for advice!
With that said, good luck with your research!
