Is My Car Accident Settlement Taxable?
The General Rule is NO
Generally, your car accident settlement is not taxable. The fundamental reasoning behind this is you are being compensated not for work, but for loss of enjoyment of life. That is a non-taxable event. This is true in the context of filing bankruptcy as well; a settlement for which you have not yet been compensated generally will not be treated as an asset in your bankruptcy filing.
The Internal Revenue Service has published an opinion regarding settlements. Here is part of that opinion:
If you receive a settlement for personal physical injuries or physical sickness and did not take an itemized deduction for medical expenses related to the injury or sickness in prior years, the full amount is non-taxable. Do not include the settlement proceeds in your income.
Medical Bills In Accident Settlements
Reimbursements or car accident settlements related to paying medical bills are also generally non-taxable. There is an exception if you have taken a prior year tax deduction for those same medical bills; however, this is a question more specifically designed to be answered by whoever prepares your tax returns each year.
Pain and Suffering
Generally, pain and suffering damages paid in a car accident are non-taxable. Again, consistent with the reasoning above, these payments are not for wages but instead meant to return you to the position you were in prior to the accident, albeit with a monetary payment. As such, these payments do not constitute income for taxation purposes.
The Lost Wages Exception
If your car accident settlement is compensating you for lost wages, that portion of your settlement may be taxable; however, most settlements are general in nature and do not specifically state that the settlement is for lost wages. Workers’ Compensation settlements are an exception. During the settlement negotiations, even if your personal injury lawyer is arguing that your settlement should be higher due to lost wages, this may not trigger a taxable settlement. When the settlement is actually reached, if it does not specifically state all or a portion is related to lost wages, you have a very good argument with the IRS that your settlement is not taxable.
Structuring Your Car Accident Settlement
If you receive a large settlement, you may choose to structure the settlement in such a way as to limit or minimize the taxability of the settlement proceeds. Primarily, you can negotiate with the insurance company to categorize as much of the settlement as possible in non-taxable language. Remember, pain and suffering is non-taxable generally, while anything assigned to lost wages may be taxable. Second, you can choose to receive your settlement over time (years), which may lessen the tax burden for each year. This is a rare situation, as most settlements are paid out in one lump sum. However, if you have a permanent disability resulting from your accident and you are receiving a lump sum for future years of lost wages, you may have a choice to receive those payments in yearly installments. This may serve to limit your tax liability. Your personal injury lawyer and an accountant can assist you with these choices as you approach settlement.
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