Is a Car Accident Settlement Taxable Income?

Snapshot

A car accident settlement isn’t taxable when the reimbursement is for medical expenses, property damage and pain and suffering. But the IRS does consider some categories of damages taxable income, most notably lost wages and lost long-term income.

In those unfortunate scenarios where car accidents involve injuries, lost wages and drawn-out settlements taking months or even years to resolve, car accidents can prove calamitous bordering on disastrous.

One contributing consideration that often gets overlooked is whether that car accident settlement you’ve waited so long to receive, is taxable. Depending on the structure and size of the settlement, that question looms like a blind spot threat in a situation you desperately want to leave behind.

Most categories of damages in car accident settlements, such as medical expenses, are non-taxable. In those categories considered taxable income, such as lost wages, the structure of the settlement could lessen the tax burden.

“The settlement agreement should allocate the settlement payment amongst the different categories of harms it compensates for,” Jeremy Babener, founder of Structured Consulting, said.

“Ideally, you allocate amongst categories that might be taxed differently like separating compartments in an oil tanker. The IRS has successfully argued that a settlement without allocations can be treated as 100% taxable even if a portion of it would have been tax-free had the settlement provided allocations.”

Do You Have to Pay Taxes on Car Accident Settlements?

Allocations to the different categories of harm can determine how much of your car accident settlement is considered taxable income.

For instance, compensation for lost wages is viewed differently by the IRS than compensation for property damages and medical costs. You would have paid taxes on wages received if the car accident never happened so when a settlement compensates you for lost wages that is a taxable category.

Likewise, damages for pain and suffering after a car accident carry far different tax implications than compensation for punitive damages. Compensation for pain and suffering isn’t typically taxable while punitive damages (which are rare in car accident settlements) are.

Car accident settlements can take a long time to resolve. If you received a previous tax deduction for itemized out-of-pocket medical expenses resulting from a car accident, your settlement amount for those medical bills could be taxed.

The lines may seem blurred to you if you’re pursuing a car accident settlement on your own. That’s understandable. It’s also why it’s recommended to consult with an accident attorney before reaching settlement.

If you’ve already reached a settlement and have questions about tax implications, consulting with a tax expert is a good way to protect your interests.

“Many settlement planners have knowledge about tax treatment, or a good connection with a CPA or tax lawyer who does,” Babener said.

“A victim should make sure their settlement planner is familiar with the issues. In general, members of SSP (Society of Settlement Planners), AASC (American Association of Settlement Consultants) and NSSTA (National Structured Settlement Trade Association) have that knowledge.”

When Car Accident Settlements Are Taxable

The idea of an insurance settlement after a car accident is to make the victim whole again. The parties negotiating that settlement often have different opinions regarding fair compensation but the categories of harm that meet the criteria aren’t at issue. And those categories are generally not taxable.

There are some damages associated with car accident settlements that are taxable:

  • Lost wages: Since wages are taxable income, compensation for lost wages is taxable income, too.
  • Lost long-term income: The same theory applies here.
  • Interest: A lump-sum settlement deposited in your bank will gain interest and is subject to taxation.
  • Punitive damages: The IRS considers punitive damages income so they must be declared on your tax return. But they are aimed at deterring a defendant’s repeat behavior, and thus are rarely part of car accident settlements.
  • Emotional distress: This is taxable unless it’s determined it stems from related physical injuries or sickness.

“Punitive damages are subject to taxation, but it’s uncommon these are awarded,” Allen Clardy, founder of the Clardy Law Firm, said. “Punitive damages are assessed when conduct is so reckless against the community that an example needs to be made to deter it from occurring in the future. An example is speeding at 100 mph through a school zone. This type of damage is taxable as personal income.”

When Car Accident Settlements Are Not Taxable

Whether your compensation after a car accident comes from a settlement or from a judgment following a trial, most of the damages you’ll receive are not taxable and don’t have to be declared on your tax return.

The exception would be if you previously took an itemized deduction for medical expenses deriving from a car accident.

Car accident settlement damages that are not taxable include almost everything except lost wages and lost long-term income.

  • Medical expenses: This is often the largest category of compensation. It’s hardly surprising since it includes surgeries, hospital stays, doctor care, medical devices, prescriptions, lab work and physical therapy.
  • Property damages: Money received to repair or replace a vehicle damaged in a car accident is not taxable. The same goes for rental car costs incurred.
  • Pain and suffering: Damages are awarded for pain and suffering to compensate victims for injuries, plus physical discomfort deriving from the accident. Treatment often falls under the category of medical expenses.

How to Reduce Taxes on Car Accident Settlements

If the amount of compensation for lost wages or lost long-term income in a car accident settlement is significant, a consultation with a tax professional or experienced car accident attorney is recommended to inform, and potentially reduce, your tax liability.

“(A) significant consideration is when a recovery is large and it may benefit clients to structure the settlement with an annuity or structured settlement,” Daniel J. Siegel, Secretary at American Bar Association, Law Practice Division, said.

“Another option is to place the settlement payout in a trust, where it can be stored and managed to also reduce tax implications,” Tyler Kobylski, attorney at Staver Accident Injury Lawyers, P.C., said. “An accident victim might choose a lump sum, structured
settlement, or trust depending on how and when they plan to use the funds.”

If a settlement that compensates you for a significant amount in lost wages and/or lost long-term income puts you in a higher tax bracket, a tax professional might help you navigate a settlement that limits your liability over a longer period.

“Most settlements are paid in a lump sum,” said Juan Dominguez, CEO and Founding Partner of the Dominguez Firm in Los Angeles. “Nonetheless, car accident victims can request a structured settlement. This form of payout is most common for those under the age of 18 or with long-term injuries.

“Like lottery winnings, a structured settlement can help with taxes vs. receiving all the money all at once. Your tax liability can be reduced if you spread it out over several years. So, the tax bill for a $5 million settlement will be far greater than one for $250,000 per year over 20 years.”

Car accidents can be scary. Car accident settlements can be painstaking and confusing.

Accident attorneys aren’t tax experts and vice versa. But often an experienced attorney can refer you to a tax professional who can answer all your questions about the tax implications of the car accident settlement coming your way.

“Your personal injury attorney and accountant can complement each other,” said Dominguez. “They each have unique skill sets that can benefit you and help you deal with the taxes associated with your settlement.

“Your personal injury attorney can give you a full breakdown of your settlement and point out what is taxable and what isn’t. But most personal injury lawyers don’t specialize in tax law. If your tax situation is more complex, you’ll want to consult with an accountant to see what the best course of action should be.”

Robert Shaw

Robert Shaw is a writer based in Ohio who brings decades of newspaper experience as a reporter, columnist and editor to his freelance work. Shaw has written on topics as diverse as the city of Atlanta's successful bid to secure the 1996 Summer Olympic Games, to the educational challenges faced by an urban Cleveland school during the Covid-19 pandemic, to federal home buying loan programs designed to help teachers, firefighters, police and emergency personnel get a foothold in the housing market. Whatever the topic, Shaw strives to bring a sharp focus and clear understanding to the issues affecting people's everyday lives.

Sources:

  1. Valet, M. Tilford, A. (2021, August 5) Are car insurance settlements taxable? Retrieved from https://www.insurance.com/auto-insurance/life-events/are-car-insurance-settlements-taxable.html
  2. Wood, R. (2019, July 1) Five Key IRS Rules On How Lawsuit Settlements Are Taxed. Retrieved from https://www.forbes.com/sites/robertwood/2019/07/01/five-key-irs-rules-how-lawsuit-settlements-are-taxed/?sh=11bc5ea34db0