A common question asked, particularly as tax season arises, is whether a settlement from a car accident is considered taxable income. In many types of lawsuits, such as breach of contract cases, discrimination and employment cases, an award may be considered income.
If a person receives a large sum of money due to a settlement, tax consequences must be considered. But in car accident cases where physical injury is involved, the answer is no. It does not matter whether the case was settled before trial or a jury returned a verdict. There are exceptions for certain items of recovery.
Physical Injury Requirement
The IRS has determined that if a person involved in a personal injury lawsuit suffered a physical injury, payment for medical expenses, lost wages, pain, suffering and emotional trauma is not considered taxable income.
The IRS has also stated that emotional distress is not, itself, considered a physical injury. Since most car accident cases involve some type of physical injury, the rule covers nearly all auto accident settlements.
Exceptions to the Non-Taxable Rule
There are a few exceptions to the rule, but these exceptions mostly affect only portions of a verdict or settlement:
Interest on the verdict or settlement – If the court happens to award prejudgment interest on a verdict or the settlement provides for pre-settlement interest, the interest portion is taxable. In Oregon and Washington State, prejudgment interest usually is not awarded in a personal injury case. Any interest collected after the judgment is considered taxable. Oregon provides for nine percent interest on judgments and interest is not commonly included in the proceeds.
- Punitive damages – If a portion of the settlement is allocated as punitive damages, that portion of the payment is taxable and must be reported as miscellaneous income on a tax return.
- Payment for medical expenses previously deducted – Often people will be able to deduct a portion of their medical expenses on Schedule A of their 1040 return. If a person deducts medical expenses from a car accident and later receives payment for those expenses in a settlement, the amount deducted is considered taxable income.
- Interest earned on proceeds of a settlement – Interest earned on the money received from a settlement is taxable. For instance, a party has a net recovery from a settlement of $200,000. The party places the money in a financial account and earns 5 percent interest or dividends on the account, or $10,000. The $10,000 is taxable income. On larger settlements, some parties may agree to a structured settlement, where interest earned is tax deferred.In most cases, an injured party can rest assured that the settlement proceeds will not be taxed, and can be used in the manner for which they were intended, to compensate them for injuries suffered.