Are Car Accident Settlements Taxable?

Key Takeaways

Some of the key takeaways you’ll have after reading this article include:

• The federal tax code states that all income is taxable unless it is exempted.
• Taxation of settlements depends on what the payment replaces.
• There are different types of damages, and only some of them are taxable.

What Does the IRS Say?

According to the IRS, damages in a car accident or other type of personal injury lawsuit fall into three categories:

• Actual or compensatory damages 
• Emotional distress or general damages
• Punitive damages

The general rule is that actual damages, which include medical expenses and other expenses incurred because of your injuries, are not treated as income. They are not taxable provided they are incurred because of physical injuries. 

Lost wages may be taxable if you recovered them in a lawsuit filed against a former employer for wrongful termination or for breach of contract. Lost wages recovered in a person injury claim due to physical injuries are not taxable, but wages recovered because of time lost as a result of emotional distress may be taxable.

The tax code also excludes from gross income the pain and suffering and other emotional distress damages recovered in a car accident lawsuit. Exclusion from gross income means they are not subject to federal income taxes.

Punitive damages are awarded to punish someone for egregious behavior, such as another motorist who crashes into you intentionally. Punitive damages are taxable unless awarded in a wrongful death case.

Compensation for Medical Bills

The general rule followed by the IRS is that payments you receive through a settlement or award as compensation for a loss are not income, so they are not taxable. Expenses incurred for medical care and treatment that are part of the settlement compensate you for a loss, so that portion of the settlement would not be taxable. However, there is an exception to the general rule.

If you paid medical bills related to your car accident and claimed an itemized deduction for them on your income tax returns in previous years, you may be taxed on the portion of a settlement that reimburses you for those medical bills. The portion of the settlement reportable as income is the amount of the tax benefit you received in the prior tax year as a direct result of the tax deduction that you claimed.

The following are some of the typical medical expenses incurred as a result of injuries suffered in a car accident:

• Ambulance transportation services
• Emergency department costs
• Fees charged by physicians and other health care providers both in and outside of the hospital
• Diagnostic imaging and laboratory tests
• Hospital charges when admitted as a patient
• Surgical expenses charged by the hospital or other facility 
• Prescribed medications
• Physical therapy and rehabilitation 
• Home nursing care
• Specialized equipment for home care, including hospital bed, wheelchair, and oxygen

If your doctors anticipate surgery or other medical care in the future, your personal injury attorney will strive to have it included in the settlement.

Compensation for Lost Wages

Lost wages recovered through personal injury settlements for car accidents generally are treated as taxable income as long as they are the result of missing work due to physical injury or physical sickness. If you missed time from work because of emotional distress, the lost wages received through a settlement with an insurance company may be taxable. These rules apply to all forms of lost compensation, including:

• Lost income
• Lost earning capacity
• Earnings lost through aggravation of a pre-existing injury or medical condition

A lawyer who knows the tax laws should be consulted if you are unsure about tax consequences of your settlement.

Compensation for Pain and Suffering

Compensation for the physical pain and emotional harm you endure as a result of the injuries sustained in a car accident are referred to as non-economic damages. Non-economic damages also include compensation for the loss of enjoyment of life because your physical injuries prevent you from participating in the activities that you enjoyed engaging in before being injured in the accident.

Internal Revenue Service rules specifically exclude money received from an insurance company or through an award after trial for pain and suffering from inclusion as taxable income. However, if you are paid money for emotional distress unrelated to physical injuries or physical illness, it may be subject to taxation.

Compensation for Emotional Distress

If you make a claim for emotional distress damages against the person responsible for causing an auto accident, the recovery through settlement or judgment may be taxable as income. Unless the emotional distress is related to physical injuries or physical illness, you may be subject to a tax liability for the emotional distress portion of the settlement or judgment.

Compensation for Property Damage

A personal injury case may also include a claim for property damage to your vehicle. As with medical costs and other forms of compensatory damages, that portion of auto accident settlements paid for damage to property is not reportable income, so it is not taxable.

It does not matter whether you receive a check from the auto insurance company to pay for repairs or to replace your car or other property damaged in the accident. The payment that you receive for property damage through an insurance settlement or jury award is not reportable as taxable income because it reimburses you for a loss that you incurred.

Punitive Damages

Punitive damages may only be awarded when authorized by state law. If you live in a state that allows a judge or jurors to award punitive damages, there are a few things you should know about them.

Unlike other types of damages awarded after a trial or as part of a settlement agreement to compensate a plaintiff for losses resulting from an auto accident, the sole purpose is to punish a defendant for egregious conduct and deter the person from engaging in similar behavior in the future.

The punitive damages portion of a personal injury settlement or award must be reported on your income tax return. You are responsible for payment of taxes on it because it is not paid to you as compensation for a loss. 

Conclusion

Getting a settlement for personal physical injuries and property damage caused by the negligence of someone else may create a taxable situation depending on the facts and circumstances of the case and specific damages that you recover. If you fail to report taxable income, you could be subject to penalties and interest imposed by the IRS on top of the taxes that you owe on the money.

Avoid tax problems by consulting with your lawyer or tax adviser about punitive damages, medical expenses and other damages payments that you receive that may be tax taxable under federal and state law. Prompt reporting of settlement payments that are taxable avoids penalties and interest.