How are car accident insurance settlements taxable?

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Here's what you need to know...
  • It’s important to remember that there are several aspects to any insurance claim
  • Under current federal law, you can claim a deduction for expenses that exceed 10 percent of your adjusted gross income
  • In the case of emotional distress, or pain and suffering, the IRS reports that this is not taxable income provided it is directly related to a personal physical injury or sickness

If you’ve received financial compensation after an auto accident, then you may have questions about how the payment will impact your local, state, and federal taxes.

It may seem confusing, but the fact is that insurance payments can be taxable or tax-exempt, depending on what the payment was made for.

It’s important to fully understand this issue so that you can avoid penalties and fines at all levels. Before you file your taxes, here’s the information you need to have regarding settlements and the tax bill.

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Money Paid as Compensation is Not Taxable

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It’s important to remember that there are several aspects to any insurance claim. You have compensation for property damages and reimbursements for medical bills.

If the money received was given to put your life back into pre-accident condition, then it is not taxable.

According to Cars Direct, this would include payments that covered:

  • Compensation for car repairs
  • Reimbursements to repair damage to other property
  • Money received for medications
  • Funds used to cover medical treatments
  • Emotional distress payments

The bottom line here is whether you would have spent money on these items or can prove that you had fees related to them.

You are only being reimbursed for the expenses you incurred while getting your property and health back in good condition, you will not be bringing extra income into the home so there’s nothing to tax.

Under current federal law, you can claim a deduction for expenses that exceed 10 percent of your adjusted gross income.

There is one exception to this, and that lies within your tax return.  If you claim medical expenses related to an accident and are later reimbursed for them, then you would lose the deduction.

In this case, you would be required to make the correction in the year that you received the settlement and pay the difference in taxes.

While you won’t be taxed on the actual payment, you will lose a tax benefit that was assumed before the payment was received.

In the case of emotional distress, or pain and suffering, the IRS reports that this is not taxable income provided it is directly related to a personal physical injury or sickness.

Here are a few guidelines to follow:

  • The pain and suffering must be directly related to an injury or illness
  • The lawsuit must specify which funds are allocated for pain and suffering
  • If these conditions are not met, then the proceeds are taxable

The good news is that you can lower the amount of any reportable income by deducting any medical expenses associated with the emotional distress.

While the taxes will still have to be paid, you can effectively lower the burden by taking these deductions.

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Treated as Income

Many insurance claims include lost wages. State and local governments have a very clear view on this. You would have been taxed on the income earned, so you should be taxed on the lost wages reimbursed as part of a claim.

According to NASDAQ, it is considered taxable income and should be entered as such when you fill out your federal taxes.

Punitive damages also count as income. These damages are awarded by the courts as a way to encourage a company to change future behavior.

It is an amount that goes above and beyond any payments made for compensation, lost wages, or pain and suffering.

When a settlement comes through and you’re viewing the final amounts, remember that any income from punitive damages is taxable and should be claimed.

Loss-in-Value of Property

In the case of property damages, you will have an impact on your taxes regardless of the amount received. If the settlements are for less than the adjusted basis of the property in question, then you will not have to pay taxes on the proceeds.

You will, however, have to reduce the property basis by the amount of the settlement.

If the amount received is great than the basis, then you’ll have to reduce the value of the property to zero and claim any remaining balance as income.

Going through a claim can be difficult and confusing, but it helps to learn more about the law.

If you understand the tax code and what parts of a settlement are taxable income, then you can prepare yourself ahead of time by setting part of the funds aside for tax issues.

Be sure to receive the breakdown in writing, and keep a copy of it on hand for when you file your taxes at the end of the year.

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