You’re finally getting a settlement for your car accident. It’s a relief to know your medical bills and damage to your car will be taken care of. But are there some hidden costs you hadn’t thought of? For example, are car accident settlements taxable?
For the most part, car accident settlements are not taxable. However, some portions may be. The final answer of what’s taxable and what isn’t boils down to the nature of the settlement and what the money is meant to compensate for.
It’s always a good idea to consult an attorney after being in a car accident. Not only will they help you reach a fair settlement, they can also help you navigate the confusing issue of taxes.
The Purpose of the Settlement Determines Taxability
When a settlement is offered, or a jury awards a judgment for a car accident, the purpose is to compensate the victim for what they’ve lost. The goal is to make the injured party “whole again,” meaning that enough money will be provided to restore the person to good health and to replace damaged vehicles and personal property.
For this reason, portions of a settlement that take care of medical bills and car repairs are not taxable. The money isn’t earned income; it’s a reimbursement. Those payments are simply getting the victim back to where they were before the accident.
The situation gets tricky when the settlement covers things that aren’t simply a dollar for dollar reimbursement. Things like punitive damages and payments for pain and suffering beyond actual doctor bills can be taxed. This is because they go beyond what it takes to make the victim whole again.
What Is Taxable and What Isn’t in Car Accident Settlements
First, it’s important to understand a bit about income tax in Illinois. Car accident claims work differently depending on your state, and taxes do too. When filling out an Illinois income tax return, the taxpayer starts with the Adjusted Gross Income calculation from their federal tax return. So, if the IRS considers something to be gross income, so does Illinois. This means that any part of a car accident settlement that is included as income on a person’s federal return will automatically be included on their Illinois return.
In some cases, tax laws are clear about what is not subject to tax. For example, if an accident victim is awarded $5,000 for $5,000 of doctor bills, it’s pretty clear that it is a simple reimbursement and therefore not taxable. The payment is not considered earned income and does not have to be reported to the IRS or Illinois at all.
Other scenarios are not so cut-and-dried. Tax laws, like many other laws, are open to interpretation. If the IRS decides that part of a settlement is taxable, it is up to the victim’s attorney to prove that the money was paid to directly compensate for a loss suffered in the accident. If that can’t be proven, the victim will be liable for the tax.
The money for settlements and jury awards is typically split into specific categories so it is clear exactly what each portion of the dollar amount is for. Here is how tax laws treat each of those categories:
As discussed above, the recovery of all necessary medical expenses is tax-free. This would include emergency medical care at the accident site, hospital stays, surgeries, doctor visits, medications, and any rehabilitation or physical therapy associated with injuries suffered in the accident.
There is one scenario where an individual could owe taxes on the medical portion of a settlement. Let’s say the individual itemizes their deductions on their tax return. Let’s also assume that they are waiting for a settlement when it’s time to file their taxes. They may claim the medical expenses they’ve paid out-of-pocket and take a tax deduction for them. The following year, when the settlement is finally paid, they will need to claim the medical portion as earned income. If they don’t, they will be “double-dipping,” or getting the tax benefit twice.
Vehicle and Property Damage
If a settlement pays to repair or replace a wrecked vehicle, or fix other property that was damaged in a car accident, those dollar amounts are not taxable. If a car is totaled, typically the amount awarded will allow the purchase of another vehicle of comparable value.
If, because of a car accident, an individual misses work, they may be awarded lost wages in a settlement. This money is taxable and must be declared on a tax return. The reasoning is that this would be taxable if it was coming directly from the person’s employer on a paycheck. It is treated just like any other earned income.
If a car accident is caused by one driver’s recklessness, the victim might collect punitive damages as part of a settlement or judgment. Punitive damages are meant to punish the driver who was at fault, not to reimburse the victim in any way.
Money for punitive damages is considered earned income and is therefore taxable. It must be claimed on the recipient’s tax return.
Mental Anguish and Emotional Distress
Car accident settlements sometimes include additional dollar amounts for the psychological and emotional trauma that the victim has suffered. This is one area that often is often up for debate when it comes to whether car accident settlements are taxable.
In order to be free of tax liability, payments for mental anguish and emotional distress must be proven to be a direct result of the physical injuries suffered in the accident. The victim’s attorney may need to go up against the IRS to present reasons why the award is justified. If the emotional suffering can be combined as part of the physical injury, the dollar amount associated with it won’t be taxable.
If arrangements are made for a settlement to be placed into some type of account or investment that earns interest, the interest is taxable. The fact it is associated with a car accident settlement that might be 100% non-taxable doesn’t matter. As the IRS sees it, the taxpayer chose an interest-bearing account, and is, therefore, making money. It is taxed just like any other taxable investment interest.
Avoid Surprise Tax Bills
Receiving a settlement for a car accident should be a welcome relief, without the surprise of an unexpected tax bill. The attorneys at Hipskind and McAninch take into account the tax impact when they structure car accident settlements. It is also a good idea to consult a tax professional to help determine whether a car accident settlement is taxable.
Accident victims deserve to be compensated with a fair settlement for their losses. The fact they may have to pay taxes on some of it is no reason to skip pursuing a valid case.