According to IRS Publication 525, “Taxable and Non-Taxable Income,” the Internal Revenue Service states:

“Do not include in your income compensatory damages for personal physical injury or physical sickness whether received in a lump sum or installments. Damages for emotional distress due to a physical injury or physical sickness are not taxable. Punitive damages are taxable. It does not matter if they relate to a physical injury or a physical sickness.”

What does this mean for the person who receives money in car insurance accident settlement? Basically, whether you are required to pay taxes depends on what the money is designated for in the settlement terms.

Medical Expenses

If you have been injured in an automobile accident, and the at-fault driver’s insurance carrier pays you for your medical costs, this money is not taxable. This is because it is not really “income,” but rather repayment of a bill for which you are already liable. In some cases, you may even have paid the medical bills out of your own pocket; if this is the case, this reimbursement is yours without penalty. However, you should be aware that your health insurance or your own car insurance company may also have made payments toward these bills. If this is the case, any money you collect from another insurance company must first be paid to your insurers to reimburse them for the forwarded costs. You are still allowed to keep any money for reimbursement of a deductible which you have paid.

Damages and Repairs

You may also keep any money you collect for damages to your car if you have paid for the repairs yourself or paid a deductible toward your collision policy. If your car insurance company has paid to have your car repaired, you must first allow the insurance company to collect its outlay before you keep the residual amount. None of this money is subject to income tax; as with the example above, it is not income but a reimbursement of money paid.

Emotional Damages

The issue of emotional damage and punitive damage is a bit murkier, and this area is where many people misunderstand the intent of the IRS’s rule. The IRS will apply a test to see if your reimbursement is for emotional damage or punitive damages. First, the IRS may ask to see a copy of your settlement agreement. This document will explain exactly how much the defendant paid and in what categories it was classified. Second, the IRS may ask for substantiating documentation such as psychiatrist or psychologist reports, counseling bills, or other forms of documentation showing that you sought help for emotional issues.

Punitive Damages

Punitive damages are the only types of damages that are taxable by the IRS. Punitive damages are “extra” money over and above the cost of medical treatment and payments for physical and emotional damage. Punitive damages are intended to punish the person who caused the accident for his or her reckless behavior. Some people become confused between what is considered “punitive” damages and what is considered compensation for physical or emotional injury. A good rule of thumb is that physical and emotional injury payments are usually tied to some specific medical bill or procedure, while punitive damages are “extra.”

Sometimes punitive damages may be more than the total of all “real” damages, so understanding the tax law in this regard is very important. All punitive damages are subject to income tax, and must be added to the total of your gross annual income. It is possible that adding this amount to your annual income will change your tax bracket and percentage, so it is very important to plan to set some of this money aside for tax purposes.

Why you Need Professional Legal and Tax Advice

When filing suit for damages sustained in an automobile accident, a good lawyer will be sure to outline in the complaint exactly how much is being asked for in each category of damages: physical, emotional, and punitive. He or she will also be sure the judgment is written up with as much weight placed on emotional damage as possible, rather than listing everything as punitive damage which is taxable.

If you are unsure about which portion of your automobile insurance settlement is taxable, talk to a tax expert such as an accountant or an attorney before you spend any money. You can have this expert help you look at your entire tax picture before you file so that you will have ample time to make plans to pay your taxes.