Posted in Blog on May 23, 2019
After you receive a car accident settlement, you might think the hard part is over. You fought for compensation for your damages and won. The at-fault party’s car insurance company has awarded you a settlement to pay for your losses. Come tax time, however, you may face a new ordeal – dealing with how the tax law applies to your settlement. Find out if settlements are taxable in the U.S, and how to navigate your responsibilities to the Internal Revenue Services (IRS).
The IRS states that, for the most part, settlements are not taxable. Most car accident settlements are free from taxation, meaning you (the recipient) will not have to pay taxes on the amount won come tax time. However, the IRS does name a few exceptions to the general rule. Some aspects of settlement proceeds may be taxable in certain situations.
Lost income settlement amounts are taxable because most lawsuits result in recovery of the victim’s gross lost wages. This is the pre-tax amount. As the victim, since you did not pay taxes on your recovered wages upon receiving the settlement, you must eventually pay taxes as you would have if the accident had not happened. If you receive payments through an annuity a car insurance company had to purchase for your benefit, this money is non-taxable. However, any money the insurance company pays you directly is taxable.
If you receive financial compensation for your emotional distress damages, including mental anguish, the IRS may tax this award. However, this only applies to emotional damages. The IRS will not impose taxes on pain and suffering that resulted from a physical injury. For example, after a car accident, a pain and suffering award for a broken bone would be non-taxable, but a pain and suffering award for post-traumatic stress disorder would be taxable.
Punitive damages are additional compensation awards a judge may assign if he or she believes compensatory damages are not enough to reimburse a victim. A judge may also use punitive damages to punish a defendant for gross misconduct or a serious wrongdoing. If any part of your car accident settlement is punitive damages, this amount will be taxable.
If you received a settlement for physical injury or illness and did not list your related medical expenses as deductions on your previous tax statement, the full amount of your settlement will be nontaxable. You will not list the settlement you won as part of your income. If, however, you did list your medical bills as deductions, you must then list the settlement as earned income. Otherwise, it will be as if you receive payment twice for the same expenses.
You may have a few options for minimizing how much tax you must pay on your car accident settlement. First, consider structuring your settlement. Structuring means receiving pieces of your settlement bit by bit over time. A structured settlement allows you to exclude some lost wage awards from each year’s taxes, saving on interest taxation. Working with the insurance company to classify your pain and suffering damages as pain and suffering related to your injury could also help you reduce your tax burden. A lawyer can help you structure your settlement for the best tax advantage.