Many taxpayers in the United States assume, albeit erroneously, that once the check from insurance settlements arrives, it is all theirs with no extra form of payment. This is not always the case, as the IRS has clear rules about which types of insurance settlements are taxable and which are not.
Legal settlements come in many forms. Some stem from lawsuits or claims revolving around personal injury, property damage, defamation, breach of contract, and other civil matters that there might be. Insurance settlements, in particular, are settlements designed to compensate the holders for losses they might have suffered due to unexpected events like accidents, natural disasters, liability claims, theft, sickness, and many others.
However, the fact that money is received as part of the settlement does not mean that it is tax-free. The determining factor in whether it should be taxed or not is what the settlement is compensating for.
What settlements does the IRS consider taxable?
According to the IRS, compensatory damages for physical injuries or physical sickness are generally not taxable, provided you did not take an itemized deduction for medical expenses related to the injury in previous years.
However, interest and compensation for non-physical injuries, such as emotional distress, are taxable. Some common insurance settlement types and their tax treatment under the IRS rules include:
Personal injury settlements (physical injuries)
These are settlements received for personal injuries or physical sickness and they are generally excluded from gross income. Personal injury settlements are generally not taxable.
Note that if you previously deducted medical expenses for the same injury and still later receive a settlement reimbursing those expenses, it may become taxable.
Emotional distress settlements.
Whether this is taxable or not depends on if there is a physical distress. If the emotional distress is linked to physical injury, it is not taxable. However, if the distress is as a result of a nonphysical injury such as harassment or discrimination, the IRS considers it taxable income.
Property damage claims.
If you receive an insurance settlement for property damage to just restore your property to its previous condition or value, it is generally not taxable. However, if you receive more than the property’s value after accounting for depreciation, the excess may be considered taxable.
For example, if you receive $15,000 for a car worth $15,000, it is not taxable.
However, if you receive $20,000 for a car with a depreciated value of $10,000, $10,000 is capital gain and is taxable.
Disability insurance settlements.
This is taxable depending on who paid the premiums. If you paid the disability insurance premiums with after-tax dollars, the benefits are not taxable.
However, if your employer paid the premium and did not include the value as income, the benefits are taxable.
It is crucial to have an in-depth understanding of these, as failure to do so can lead to unexpected tax liabilities or penalties.
