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For the most part, money you receive as part of an insurance claim or settlement is not taxed. The IRS only levies taxes on income—money or payment you receive that results in you having more money than you did before. Since the purpose of insurance is to "make you whole," you should generally only receive enough payment to bring you back to the state you were in before an incident occured. You might receive hundreds or thousands of dollars in payout from an insurance company to fix your car, but if the money is only used to make you whole, it wouldn't be taxable. But the way this works is slightly different for every form of insurance.
Claims to Repair or Replace Your Home, Car or Other Property Aren't Taxed
One of the most common reasons you receive money from an insurance claim is to pay for the repair or replacement of a damaged piece of property. This could be a car insurance claim paying to fix your vehicle after an accident, your homeowners insurance proceeds paying to repair your house after a natural disaster or renters insurance paying for personal property that was stolen from you.
In all of these cases, you don't have to pay taxes on the compensation because you aren't gaining anything; you're only being returned to the state you were in before the incident. Imagine you own a car worth $10,000, and it's totaled totaled in an accident. After the claim is settled and you are compensated with $10,000 toward a new car (minus the deductible), you are in the same place you started. You haven't gained anything—haven't had any income—so the IRS won't charge you.
The only exception to this is if you have extra money left over from your claim after your property has been replaced or repaired. The two ways this might occur are if the insurance company overpaid you, or if you performed the repair yourself, and paid yourself for doing so. If you do have to pay taxes on an insurance claim, you'll receive a 1099 form to help you file.
Medical Claims Aren't Taxed
Any kind of medical claim you make to insurance, whether it's part of a settlement you make after an accident or simply a claim for a medical appointment, won't be taxed. For example, if you're in a car accident and incur $500 in medical expenses, your personal injury protection (PIP) coverage would reimburse you. But since the $500 is only reimbursing you for money you previously spent, you don't have to pay taxes.
When you're making a health insurance claim, it's likely that you won't touch any money at all, because health insurance companies most commonly pay doctors directly. But even if you paid out of pocket for a medical expense and are reimbursed later, you won't have to pay taxes on the amount you're paid.
You can actually save even more on your medical bills and taxes by using a flexible spending account, or FSA, to pay the bill. FSAs are most commonly offered as a benefit through your job. When you sign up for an FSA, you set aside a certain amount of money per year pre-tax to spend on medical expenses. You can use it to pay deductibles and coinsurance for doctor's visits, filling prescriptions and more. But money you put into an FSA generally expires at the end of each year, so you should only put in as much as you think you will spend in a given year.
Life and Disability Insurance Claims May Be Taxed
Insurance payments that are designed to replace or supplement income may also be subject to taxes. A life insurance payout—the kind that's distributed after the insured person dies—isn't taxed. But any interest gained from the payout, or any money you withdraw from a cash value life insurance policy while the insured person is still alive, is counted as income and taxed as such.
Additionally, short- and long-term disability insurance proceeds, which are both designed to provide you with income if you're unable to work, are taxed the same way income is. You'll need to report these payments as earnings when you're filing.
Lawsuit Proceeds May Be Taxed
If your insurance claim has evolved into a lawsuit, the tax situation gets more complicated, as you could receive several different forms of compensation, all of which may be taxed in different ways.
Just like a normal insurance settlement, compensation for medical bills and repair of property are not taxed in a lawsuit. However, many types of payout that you may receive as a result of a legal settlement are taxable, whether the case is ultimately settled in or out of court. For example, if someone hits you in an auto accident, you wouldn't be taxed for a payment you receive for your medical bills. However, if the judge also awards you punitive damages, you would have to pay tax on those. If you do receive taxable payment from a lawsuit, you'll likely receive a 1099 form to use when filing your taxes.
Common taxable payouts from lawsuits include:
- Punitive damages
- Lost wages
- Pain and suffering (unless caused by a physical injury)
- Emotional distress