Lost Wages Insurance Payouts: Taxable?

Lost wages compensation is generally considered taxable income. However, the Internal Revenue Service (IRS) does not tax income that does not make the recipient wealthier than they were before. For example, compensation for lost wages is taxable because it replaces income that would have been subject to income tax.

Lost wages and income tax

In most cases, lost wages are considered taxable income by the Internal Revenue Service (IRS). This means that any compensation received for lost wages will typically be subject to income tax. The rationale behind this is that the income would have been taxed if it had been earned through regular employment. Therefore, it is important for individuals to be aware of the tax implications when receiving compensation for lost wages.

Not all types of compensation are taxable. The IRS has specified certain exceptions where compensation is not subject to taxation. These include:

• Property damage: Compensation received for property damage, such as the loss of a vehicle or its contents, is generally not taxable. This is because individuals have already paid taxes on that property, and they are typically not profiting from these types of compensation.
• Personal physical injury or sickness: Any income received as compensation for personal physical injuries or physical sickness is generally excluded from taxation. This includes medical expenses directly related to the injury or sickness.

There are certain stipulations to the exceptions mentioned above. For example, emotional distress is not considered a physical injury, and compensation for emotional distress is typically taxable. Additionally, if the compensation for medical care exceeds the actual damages incurred, that excess amount may be subject to taxation. Ultimately, the taxability of compensation depends on the specific situation and the amount received.

Withholding Taxes on Lost Wages

When paying compensation for lost wages, the payer is responsible for withholding income tax. They should provide the recipient with the appropriate IRS form, such as a W-2 or 1099, depending on the circumstances. However, it is still the recipient's responsibility to report that income when filing their taxes for the following year.

Special Notes for Specific Damages

Some types of damages are always subject to taxes, while others are generally not. Punitive damages, which are awarded for extremely reckless behavior, are taxable because they are considered monetary rewards. On the other hand, property damage is typically not taxable, as individuals have already paid taxes on that property.

Emotional distress is another type of damage that is generally taxable. While individuals may have received medical treatment for emotional distress, the IRS considers compensation for distress as separate from direct medical expenses.

Personal injury and medical expenses

Compensation for physical injuries or physical sickness is not taxable. This includes out-of-pocket expenses, such as medical bills and lost income. It also includes non-economic harm like "pain and suffering".

However, if you deducted medical expenses in previous years, you may have to pay tax on them if the deduction provided you with a tax benefit.

Compensation for emotional distress, mental anguish, defamation, and humiliation is taxable unless it can be attributed to a physical injury.

Punitive damages and interest on settlements are taxable. Punitive damages are meant to punish the person or organisation that caused harm, rather than compensate the victim. Interest on settlements is considered "Interest Income".

In the US, most states follow federal guidelines and don't tax personal injury settlements and judgments.

Property damage claims

Property damage can be covered by liability, collision, or comprehensive insurance, depending on what caused the damage. If you were involved in an accident, you’ll file a claim with your insurance company or the other driver’s, depending on who was at fault. Once you file a property damage claim, the insurance company will assign an adjuster to your case who will oversee the process and give you a final settlement offer.

• Report the damage to your insurance company.
• File a police report.
• Work with the insurance adjuster.
• Get your vehicle repaired.
• Finalize your insurance payout.

When filing a property damage claim, it's important to note the difference between when the damage is related to an accident and when it is unrelated. If your vehicle was damaged by something other than a collision, you need to file a claim with your own insurance company under your comprehensive coverage. Comprehensive insurance policies are optional and cover vehicle repairs or replacement needed due to a wide range of events such as natural disasters, vandalism, or theft.

On the other hand, if the damage was caused by an accident, there are multiple ways to go about filing a property damage claim. If the other driver is at fault, you need to file a claim with their insurance company. Their liability insurance will cover any repairs to your vehicle up to the limits of their policy. If you’re at fault, your own collision insurance policy will have to cover your vehicle’s damage since your liability insurance will only cover expenses incurred by other people in accidents that you cause.

In cases where the fault is shared or unclear, you would file a claim with both your insurance company and the other driver’s. Once a claim has been filed, an insurance adjuster will investigate the accident and determine who was at fault. You’ll then get coverage under one or both policies, depending on the negligence laws in your state and what percentage of responsibility you both share.

It's important to note that property damage claims have specific timelines for reporting an accident and filing a claim, which can vary depending on your state. Additionally, the longer you delay your claim, the harder it will be to defend it. Therefore, it is advisable to report any damage to your insurance company as soon as possible.

Excess amounts and other payments

In the United States, compensation for lost wages is generally taxable. However, there are exceptions to this rule.

Excess Amounts

If the compensation you receive exceeds the damages for medical care, that may be taxable.

Other Payments

Punitive Damages

Punitive damages are always subject to taxes. Punitive damages are taxable because they do not compensate you for out-of-pocket losses. Essentially, they are income or money you didn't have before the crash.

Emotional Distress

The IRS stance on this is that while you may have undergone some medical treatment to address emotional distress, such as therapy, compensation for distress doesn’t directly address medical expenses.

Interest on Frozen Deposits

If you have received a large settlement, you may end up depositing some of the money in a bank account or mutual fund to earn interest on the money. In this case, you would have to include any interest earned on your tax return as it would be considered income, which is always taxable.

Interest on Qualified Savings Bonds

If you have received a large settlement, you may be able to exclude from your income the interest on qualified savings bonds. This exclusion applies only to interest earned on qualified U.S. savings bonds issued after 1989.

Interest on State and Local Government Obligations

Interest on state and local government obligations is generally exempt from federal income tax.

Interest on Frozen Deposits

If you have received a large settlement, you may end up depositing some of the money in a bank account or mutual fund to earn interest on the money. In this case, you would have to include any interest earned on your tax return as it would be considered income, which is always taxable.

Interest on Frozen Deposits

If you have received a large settlement, you may end up depositing some of the money in a bank account or mutual fund to earn interest on the money. In this case, you would have to include any interest earned on your tax return as it would be considered income, which is always taxable.

Interest on Frozen Deposits

If you have received a large settlement, you may end up depositing some of the money in a bank account or mutual fund to earn interest on the money. In this case, you would have to include any interest earned on your tax return as it would be considered income, which is always taxable.

Federal disaster areas

In the United States, the Internal Revenue Service (IRS) provides disaster tax relief to individuals and businesses affected by federally declared disasters. This includes taxpayers whose principal residence, place of business, or records necessary to meet a filing or payment deadline are located in a covered disaster area.

When a disaster occurs, the Federal Emergency Management Agency (FEMA) conducts a preliminary damage assessment at the request of the governor of the affected state. FEMA then issues a disaster declaration, identifying the areas eligible for relief. The President must also sign a major disaster or emergency declaration before the IRS can authorize tax relief for disaster victims.

In the context of federal disaster areas, there are a few key considerations regarding insurance compensation for lost wages:

• Disaster Unemployment Assistance: In a presidentially declared disaster, individuals who have lost their jobs or are unable to work due to the disaster may be eligible for Disaster Unemployment Assistance. This program is managed by the U.S. Department of Labor and administered by state unemployment agencies. It covers both employees and the self-employed, and individuals must be available and able to work to receive assistance. Applications must be filed online within 30 days of the announcement that funds are available.
• Business Interruption Coverage: Businesses may have commercial insurance policies that include business interruption coverage, which can provide compensation for lost wages during a disaster. This typically covers physical damage and may apply to shutdowns, revenue losses, and fixed costs like salaries and employee health care. However, there may be a waiting period before this coverage takes effect, and home-based workers need to purchase separate commercial coverage.
• Tax Treatment of Lost Wages: Compensation for lost wages is generally considered taxable income by the IRS. It replaces income that would have been subject to income tax. However, special tax provisions may apply in federally declared disaster areas, allowing affected taxpayers to deduct related losses not covered by insurance on an amended return from the previous year.
• Extended Filing and Payment Deadlines: The IRS may provide administrative disaster tax relief, including the postponement of filing and payment deadlines for eligible taxpayers in federally declared disaster areas. This relief is based on FEMA's preliminary damage assessments.

Frequently asked questions