Are Auto Insurance Settlements Taxable?

If you’re wondering whether auto insurance settlements are taxable, the good news is generally it's not. However, there are some cases when auto insurance settlements are taxable.

Let’s face it, understanding taxes are complicated. So, that’s why it is essential to properly learn about it so that you can duly pay the right portion of your tax while keeping as much of the auto insurance settlement as possible.

To help you get an in-depth understanding, this article discusses which types of auto insurance are taxable, which ones are exempt, and strategies to minimize your tax liability.

Which Auto Insurance Settlements Are Taxable?

The main concept of taxation is to pay a portion of your income to the country’s overall development and welfare. Typically, the amount of tax is a percentage that’s determined by the Government. It is mandatory for every law-abiding citizenship to pay their fair share of tax.

Some auto insurance settlements can be an alternative form of income, or they may generate a significant amount of income that’s taxable. If you want to stay legally compliant while leveraging the optimal benefits of your auto insurance settlements, it is crucial to learn and understand which types of auto insurance settlements are taxable.

So, here’s a detailed breakdown of auto insurance settlements that are taxable as follows.

Lost Income/Wages

If you run into an accident and get severely injured to the point where you’re unable to work, your auto insurance company will compensate the loss of income/wage. When it comes to taxation, any income or wage is taxable even if it comes from your auto insurance settlement.

Well, that’s not all, the tax that’s imposed from auto insurance settlement is considered income from self-employment instead of an employee. They will issue you tax on income based on 1099 tax form instead of W-2 (wage and tax statement) form.

With the loss of income compensation from your insurer, you’re considered an employer, and you will also have to pay tax for Social Security and Medicare. Simply put, you will have to pay tax for the auto insurance settlement that you’re getting for the Periodic Loss of Income plus Social Security and Medicare.

On top of that, it also depends on the amount that your insurer is compensating you, and whether they’re paying you all at once, or on a monthly or quarterly periodic basis.

If your insurer pays you a high amount all at once, let’s say the loss of income settlement of 3 years, then you will have to pay a significantly high percentage of income tax.

Interest Earned on Settlements

For any reason whatsoever if your insurer delays your auto insurance settlement, then they have to compensate you by paying the settlement amount with interest. Sometimes these issues are mutually settled with negotiations and mutual agreements, but in many cases, it can lead to a legal dispute between the insurer and policyholder.

Either way, when your insurer pays you the settlement amount with interest, the extra amount that you receive is considered an income. So, this means that while the original settlement may be tax-free, the extra interest amount is subject to taxation.

Emotional Distress (Unless Received with a Physical Injury)

If you receive compensation for emotional distress following an accident, it may be taxable. According to the IRS, emotional distress is only exempt from tax if it is directly linked to a physical injury.

In other words, if your emotional distress is a result of a physical injury from the accident (like pain and suffering from a broken bone), it is not taxable. However, if the emotional distress is not related to a physical injury, it is considered taxable income.

Auto Insurance Settlements That Are Exempted from Tax

Auto insurance has been specifically designed to financially protect you by covering your medical bills, vehicle/property repair expenses, and liability compensations. The reason auto liability insurance is mandatory in 49 out of 50 states in the US is to ensure every driver is financially covered against bodily injuries, vehicle damage and property loss.

As a result, certain auto insurance settlements, such as those covering medical expenses, vehicle/property repair costs, and pain and suffering, are generally exempt from tax. Here’s a detailed breakdown of these tax-exempt settlements as follows.

Medical Expenses

Any medical expense for treating physical or bodily injuries is exempted from tax. So, if you receive any auto insurance settlement to cover your medical bill, it is absolutely tax free.

However, if you previously deducted those medical expenses on your tax return and later received reimbursement through a settlement, you may need to report the reimbursed amount as taxable income to avoid a double tax benefit.

Property/Vehicle Repair Costs

One of the main reasons to get auto insurance is to financially cover your car against any accidental damage. Throughout the US any auto insurance compensation for vehicle and property damage repair costs are exempted from tax as it is considered reimbursement rather than income.

This tax exemption applies to various types of repairs, including: 

• Vehicle repair or replacement costs due to an accident

• Damage to personal property inside the vehicle, such as electronics or personal belongings

• Repairs for property damage if the accident involved structures like fences, mailboxes, or garages

Pain and Suffering Benefits

Compensation for pain and suffering resulting from physical injuries sustained in an accident is generally tax-exempt. This includes damages awarded for emotional distress, mental anguish, and loss of enjoyment of life, as long as they are directly related to a physical injury or illness caused by the accident.

However, if you receive compensation for pain and suffering without any physical injury, such as emotional distress from trauma alone, this portion of the settlement may be taxable. The IRS considers this type of settlement as income unless it is tied to a physical injury.

Tips to Reduce Tax Payable on Auto Insurance Settlements

As a responsible and law-abiding citizen, it is your responsibility to pay your fair share of tax. When it comes to auto insurance settlements, it is essential to stay vigilant and carefully determine and calculate how much tax you need to pay on settlements.

If you don’t want to get overburdened and of course minimize the amount of tax payable on auto insurance settlement, here are some effective tips as follows.

• Use Settlement Funds Wisely for Medical Expenses: If you get auto insurance settlement of $100,000, use most of it to treat physical and the rest for emotional distress/mental trauma from the accident. For example, you can use up to 60% to 70% of the settlement amount on physical injuries, and about 30% for treatment mental health issues.

• Structured Settlement: Ask your insurer to parodically pay you the auto insurance settlement progressively. For instance, you can tell your auto insurance company to cover your auto insurance settlement monthly instead of paying it all at once. If you receive a lump of auto insurance settlement at once, it shows a significantly high amount on your bank balance which can lead to increased tax.

If you want to save on tax and auto insurance, you should prioritize choosing a reliable auto insurance agency that can properly guide you and process your auto insurance settlements by prioritizing your best interests.

If you’re located in Michigan, and if you need help figuring out the complexities of auto insurance settlements you can either book a consultation or visit our office. Here in Michigan, so far, we have three regional offices to help get the best auto insurance solution which includes Flint MI, Saginaw MI and Mt. Pleasant MI.

The Bottom Line

In a nutshell, it is safe to conclude that most auto insurance settlements are not taxable, while some are. Before calculating taxes on your auto insurance settlements, it is crucial for you to know auto insurance settlements that are taxable and the ones which are not.

Here’s a quick recap though of the main auto insurance settlements that are exempted of tax which includes the following below.

• Medical Expenses
• Property/Vehicle Repair Costs
• Pain and Suffering Benefits

Here are common auto insurance settlements that are taxable and are treated as an income such as.

• Lost Income/Wages

• Interest Earned on Settlements

• Emotional Distress (Unless Received with a Physical Injury)

Even with proper knowledge about taxation on auto insurance settlements it can get quite confusing. If you need help or suggestions to determine how much tax you need to pay from your auto insurance settlements, you should consult with your insurer.

In case you need additional help, or a second opinion, you can contact us to get expert tips, and suggestions on settlement taxation, along with auto insurance coverage within your budget.

FAQs

Is money received from insurance claims taxable?

Generally, the money you receive from auto insurance claims is not taxable. However, there are some auto insurance settlements which are not taxable such as compensation for loss of income/wage, interest earned on settlements and emotional distress without any physical injury. 

What type of settlements are not taxable?

Typically, auto insurance settlements for medical expenses, property/vehicle repair costs, along with pain and suffering benefits are not taxable. 

Are auto insurance settlement payments tax deductible?

Yes, auto insurance settlements such as medical expenses are tax deductible especially because it’s exempted from taxation.