Insurance Settlements: Income Or Not?

Whether insurance settlements are considered income or not depends on the type of claim and the nature of the compensation. The Internal Revenue Service (IRS) levies taxes on income, which is defined as money or payment that results in an increase in wealth. As such, compensation from insurance claims or settlements that exceed the cost of repairing or replacing damaged property may be taxable. For instance, if the insurance company overpaid or if you performed the repair work yourself and profited from it, the excess amount may be subject to taxation. However, claims related to property damage, medical expenses, and bodily injuries are generally not taxed. On the other hand, punitive damages awarded in certain lawsuits and proceeds from life and disability insurance claims may be taxable.

Medical claims

However, there are some exceptions. If you deducted medical expenses from your taxes in the previous year, you will be obligated to include the portion you receive from your settlement as taxable income. This is because you cannot receive both the benefit of the tax deduction and compensation for your bills.

Property damage

However, there are some situations in which an insurance settlement for property damage may be considered taxable:

• Additional compensation: If you receive compensation beyond the actual cost of repairing or replacing damaged property, this could be taxed. This includes money for pain and suffering, emotional distress, or other non-physical damages.
• Business property damage: If the damaged property is used for business purposes, such as a storefront or office space, the tax treatment may be different.
• Income-producing property: If the damaged property generates income, such as a rental property, the tax implications may vary.

It's important to note that tax laws can be complex and may vary depending on your location. Therefore, it is always a good idea to consult with a tax professional or accountant to determine the specific tax implications of your insurance settlement.

Getting a Fair Property Damage Settlement

When negotiating a property damage settlement with an insurance company, it's important to gather as much information as possible about the accident. This includes the other driver's insurance information, witness statements, physical damage, and license plate numbers. It's also crucial to know what you want from the settlement, such as repairs or a total loss claim.

Insurance adjusters will rely solely on recorded and physical information when negotiating your claim, so it's important to be prepared and informed. You can also use the insurance company's repair shop to make the process more convenient and increase your bargaining power.

If your car has been totalled, you will need to transfer the car's title to the insurance company before they can pay out any settlement. They will then sell the car for scrap and pay you the remaining amount after paying off any loans or leases on the vehicle.

Temporary Repairs and Living Expenses

In most states, you have a duty to mitigate damages, including property damage in car accident cases. This means that you should not let your car sit in storage, as the storage fees will not be included in your final settlement. Instead, move the car to a storage facility or pay any costs as you go.

If you need to relocate or incur other living expenses while your home is being repaired, keep records of your expenses. Homeowners insurance policies typically provide coverage for these additional living expenses.

Working with a Lawyer

While it may not be necessary to hire a lawyer for a strictly property damage claim, an attorney can be helpful if your case is complex or the insurance company is being unreasonable. They can provide valuable negotiation experience and ensure you receive a fair settlement.

Lost income

It is important to note that the taxation of lost income can be complex and may depend on various factors, such as the structure of the settlement and the applicable tax laws. For example, if you receive a large settlement representing several years of lost income all at once, you may be taxed at a higher rate than your usual tax bracket. On the other hand, if you structure the settlement as periodic payments over several years, you may be able to reduce your overall tax liability.

To minimize tax liability, it is crucial to work with a legal professional and a tax advisor before settling your case. They can help you structure your settlement in a way that minimizes taxes and ensures you receive the maximum compensation.

Life and disability insurance

Life Insurance Claims

Life insurance payouts distributed after the insured person's death are generally not taxed as income. However, life insurance proceeds may be subject to estate taxes, depending on the size of the insured's estate and the state in which the insured and beneficiaries reside. Any interest accrued from a life insurance payout or withdrawal from a cash-value life insurance policy while the insured person is still alive is considered income and is therefore taxable.

Disability Insurance Claims

Short-term and long-term disability insurance proceeds, which provide income replacement if you are unable to work due to an injury or illness, are generally taxed as income. If you receive disability benefits through an insurance plan paid for by your employer, you must report these payments as income. However, if you pay the entire cost of the insurance plan yourself, you do not need to include any amounts received as disability benefits in your tax return.

If both you and your employer contribute to the insurance plan, only the amount you receive due to your employer's payments is reported as income. If you pay the premiums through a cafeteria plan and did not include the amount as taxable income, the benefits are considered paid by your employer and are fully taxable. You can submit a Form W-4S to the insurance company to request federal income tax withholding, or make estimated tax payments by filing Form 1040-ES.

Additionally, if you receive disability benefits from a state sickness or disability fund, an association of employers or employees, or an insurance company (if your employer paid for the plan), you must include these amounts in your income. However, you can generally exclude from income any payments received from qualified long-term care insurance contracts as reimbursement for medical expenses related to personal injury or sickness.

It is important to note that you may be able to deduct your out-of-pocket medical expenses above any reimbursements if you are eligible to itemize your deductions. Please refer to the relevant IRS publications for more detailed information.

Punitive damages

Money received as part of an insurance claim or settlement is typically not taxed. The IRS levies taxes on income, which is money or payment that results in a gain. Because the purpose of insurance is to "make you whole", insurance settlements generally only serve to restore you to your previous state. For example, if your car is damaged in an accident and you receive a payout from your insurer to fix it, you won't be taxed on this because you haven't gained anything.

However, income from certain types of claims and insurance-related events may be taxable. For instance, proceeds from life and disability insurance claims are taxed as income. Additionally, if you receive compensation for lost income in a car accident settlement, this may be taxable because it covers the loss of your normal wages, which would usually be taxed.

While punitive damages are not considered compensation for the plaintiff, the plaintiff will receive all or part of the punitive damages awarded. Punitive damages are taxable and should be reported as 'Other Income' on a tax return. However, there is one exception to this rule: punitive damages for wrongful death are not taxable if state law only permits punitive damages in wrongful death claims.

Frequently asked questions