Do You Have To Pay Taxes on Insurance Settlements?

When it comes to winning a lawsuit, you probably won’t be taking home the entire settlement. You will need to pay for things like legal fees if you haven't already paid upfront, and any help or aid that you have taken that works on a percentage basis will take their agreed cut from the settlement.

This could include things like public claims adjusters and more. Ultimately, you will be entitled to the majority of the settlement, and once you have paid all the necessary fees, then you would hope that anything that is left over will be yours to keep.

Do You Have to Pay Taxes on Insurance Settlements?

Something that you might be wondering is whether or not you have to pay taxes on insurance settlements, and this is the question that we will aim to answer in this article.

This way, you can be fully prepared on what to expect following on from an insurance settlement and what happens with the money side of things. 

Do You Have to Pay Taxes on Insurance Settlements?

Most of the time, any insurance settlements will not generally be taxed and it is not usually considered to be taxable income. It is unlikely that you will have to provide evidence of insurance claims for tax purposes, and most of the time you will not have to pay tax on your settlement.

However, as you were probably expecting, there are going to be certain instances where the government may claim a share of the settlement that has been arranged for tax purposes. 

The reason that this money is not typically taxed is due to the fact that it is not classed as additional income. The IRS  only taxes any money or payments that are received that make you have more money than you did before.

The insurance settlement is designed to make up for any losses or damages that you have incurred, which is why you typically won’t receive more money than what you have lost or missed out on. Therefore, this money will not be taxable, as it is only ‘restoring’ your financial state to what it should have been previous to an incident. 

IRS Tax Rules

The taxes that you may or may not have to pay will depend on the origin of the claim, as this is how the taxes are based. If you are claiming due to a loss of wages, you will be taxed as your wages would be.

However, if you are seeking damages, they will likely not be classed as an income. There are different exceptions to these rules that you will need to be mindful of, but this is how it generally works.

Anything that you are claiming for physical injuries or sickness will be tax-free, and you won’t have to pay any taxes on these settlements. However, symptoms of emotional distress are not physical so you are likely to be taxed on these settlements.

This didn’t used to be the case, but the law changed in 1996 to state that your injury must be physical, and otherwise, you will be taxed. However, some injuries or illnesses fall into the grey category for this, and you should be aware of any disputes before you settle. 

Some legal cases will involve more than one type of damages, which could mean that certain things are taxable whereas others are not. This can often get a little complicated, and the settlement may involve different types of consideration.

The best way to work through this is for the defendant and the plaintiff to agree on tax treatment before resolution, and these are often taken into consideration.

The entire settlement can be taxed, no matter the amount of it you receive. If you are to use a contingent fee lawyer, you are typically still classed as receiving 100% of the settlement money, even if a percentage of it will be paid out in fees.

If the case is completely tax-free, then this won’t make much of a difference to you, but if not, you will have to pay tax on the entire amount and not the amount that you actually receive.

For example, if the entire settlement amount is $120,000, and your lawyer is entitled to $40,000, it would make sense for you to be taxed on the remaining $80,000.

However, this is not the case, and you will be classed as having $120,000 additional income, and this will be taxed as a whole, regardless of how much of it you receive. 

Any punitive damages that you are claiming will always be taxable. This might only be a small part of your entire settlement, but this part will be taxed, even if the rest is tax-free.

Lawsuits and Compensation Tax

For those insurance claims that have evolved into lawsuits, the situation surrounding the tax that you pay is no longer as simple.

This is because you might be entitled to different forms of compensation, and these may all be taxed differently depending on the situation. As with any other settlement, any medical bills or property damage payouts will not be taxed, even during a lawsuit.

However, the same cannot be said for other types of payments that you may be entitled to following a legal settlement. It also doesn’t matter if the case was resolved in court or not, if there is a taxable payment, you will be taxed on the money that you receive from the settlement. 

So, if you were in a car accident, for example, and you were not responsible, you won’t be taxed on any of the medical expenses that occurred as a result of the incident.

However, if you are also awarded any additional punitive damages, then you are going to have to pay tax on them. Some other taxable payouts from lawsuits could include lost wages, pain, and suffering unless caused by a physical injury, and any emotional distress.

If you do have to pay tax on your settlement, then you will most likely receive a 1099 form that you can use when it comes to filing your taxes.