If you receive a payout from an insurance company as settlement from a claim, or if the insurance company receives a court order directing them to pay you in connection with a liability lawsuit, you are required to report the amount as income earned when you file your taxes. Whether the money you receive is a settlement, payout, or court award, the Internal Revenue Service will have access to all the pertinent information. Should you fail to report this income, you could be subject to IRS penalties and even collection in some cases. The insurance experts at American Tri-Star in San Diego discuss a few situations where you might or might not have to pay taxes on an insurance settlement.
Taxable Insurance Settlements
The requirement to report insurance settlements on your annual tax return does not automatically mean you will have to pay taxes. As a general rule, one of the first things you should do is set aside 30 percent of the amount you receive before you start spending it. This will save you from unpleasant surprises from the IRS down the line.
Within the Internal Revenue Code, there is a section that exempts insurance settlement amounts you receive in relation to personal injury and sickness. The section is 26 U.S. Code § 104, and it states that the IRS will not collect taxes on the compensation received in connection with medical conditions, disabilities, or illnesses. A good example in this regard is workers’ compensation, which is essentially a mandatory insurance system for employers. Insurance settlements paid for reasons other than those covered by 26 U.S. Code § 104 are taxable, which is why you should set 30 percent aside when you receive payment.
Separating Medical Items from Your Total Settlement
If you are injured as a result of a slip and fall accident at a supermarket and you file a civil complaint against the supermarket and later agree to a settlement, you may get a single check from the insurer providing premises liability coverage. Even if your complaint asked for lost wages in addition to medical expenses, you will still get a single check.
More often than not, the insurance settlement check will not show a breakdown of the compensation you receive. This means it will be up to you to allocate the amount that corresponds to the medical expenses you incurred as a result of slipping and falling. This will be the non-taxable portion of your settlement you can indicate on your tax return.
Medical Expenses as Deductible Items
It is important to note you may have to pay taxes on an insurance settlement if you already claimed medical expenses as deductions. This is the most common case among people who have pending liability lawsuits. Typically, you’ll want to deduct medical expenses during the tax year they occurred. Compensation related to pain and suffering is not taxable as long as it is paid in connection to an injury or medical condition caused by the respondent to a lawsuit.
If you have additional questions about insurance settlements and taxes, get in touch with American Tri-Star. We are a leading provider of auto, homeowners, health, and commercial insurance in San Diego. Call one of our knowledgeable agents at 619-272-2100 to learn more and receive a free quote.