Is Insurance Settlement Taxable ? The expectation of the IRS

Does IRS Tax insurance settlement?

If you have received an insurance settlement, you might have this question at the back of your mind: Is my car insurance settlement taxable?

There is no clear yes or no answer, as it is case dependent.

This article will help keep you updated on what the IRS expects of you.

Tax and Car Accident Settlement: The expectation of the IRS

As earlier mentioned, there is no black and white answer to the question: Am I required to pay money to the IRS from the insurance settlement received from damage to car or truck vehicles?

One thing I want to point out is that the IRS only taxes income that increases your wealth. This means you don't have to settle the IRS if you spent the money on repairing the damage on a car your own. This is because the settlement makes no dent in your net worth.

Exceptions exist. For example, the IRS can tax you on payment made to you because of emotional distress or psychological damage.

The amount paid depends on the insurance company. 

Reasons Some Insurance Settlements can be Taxed

The essence of an average insurance payout is to take you back to the initial point before the accident. So ordinarily, you are not expected to make money from an insurance payout except it is mental or emotional suffering from an accident. 

Sequel to an accident, the compensation covers medical bill and physical damages to your vehicle.

Example of a Car Accident Settlement

Let's assume a truck hit you at an intersection. Because of the accident, you suffered a fracture of the tibia that kept you at the hospital for 6 weeks. Your company paid your salary as at when due. So you suffered no salary loss. After you were discharged, you discovered you racked up a bill of $10000 as cost of medical treatment. Your auto car repair man informed you that car repairs gulped $7000.

Your insurance policy cover paid you $21000, $4000 as payment for emotional distress and missing work.

 What Amount of your Settlement will the IRS Tax?

The amount taxed is $4000 since this amount is compensation for emotional distress and workers' compensation for absence from work..

In summary, a breakdown of what's taxable and non-taxable from an insurance settlement

  • Medical bills (non-taxable)
  • Emotional pain compensation(taxable)
  • Workers' compensation/ lost wages(taxable)
  • physical pain/suffering (non-taxable)

What is Taxable From an Insurance Settlement?

To review, here is what is and isn’t tax exempt in insurance settlement payments:

  • Car repair/replacement - Tax exempt
  • Lost wages - Taxable
  • Medical bills - Tax exempt
  • Physical pain/suffering - Tax exempt
  • Emotional pain/suffering - Taxable

Why Car Repair and Replacement is Non-Taxable?

The reason is that it doesn't cause an increase in your income.

Why Workers compensation or Lost Wages is Taxable?

Lost wages are usually taxed because the IRS considers it to be taxable gain. The IRS considers lost income as income instead of reimbursement.

However, if the injury is prolonged, taxes become complicated. In such a case, your insurance company may pay you compensation for future missed earning. Future missed earnings may attract higher tax rate.

Reason You don't Pay Tax on Medical Bills

Medical bills are not considered income but expenses. The IRS does not tax expenses. Your insurance company either pays the medical bills directly or reimburses you if you've already made payment.

However, there is an exception. According to Investopedia:

If you incurred substantial medical expenses not covered by insurance, you might be able to claim them as deductions on your tax return.

These costs include health insurance premiums, hospital stays, doctor appointments, and prescriptions.

Other eligible costs that are frequently overlooked include alternative treatments like acupuncture, well-child care for newborns, hotel stays for medical visits, and special diets.

The deduction for tax year 2022 covers expenses that exceed 7.5% of your adjusted gross income (AGI).

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