Before you report taxes on an insurance settlement on your Form 1040, you must know which settlement proceeds are considered taxable by the Internal Revenue Service and which are not. The answer depends on the nature of the lawsuit and the settlement. Typically, personal injury settlements are not taxable but punitive damage settlements and compensatory settlements are taxable. Report taxable settlement amounts on Line 6 of Form 1040 after completing Schedule 1 (1040).
After reporting taxable settlement proceeds on Line 21 (labeled "other income") of Schedule 1 (1040), add Lines 1 through 21 and enter the sum on Line 22 before transferring this sum to Line 6 of Form 1040.
Tax Liability Implications of Settlements
Taxable settlement monies are taxed at ordinary income tax rates, although it is likely the settlement will put you into a higher tax bracket.
Keep in mind that if your attorney took a contingency fee from the settlement, which often runs from 35 to 40 percent of the total, you will have to report the entire amount. However, you can deduct the amount of the attorney’s fees on Form 1040’s Schedule A.
Personal Injury Settlement Not Taxable
Most personal injury settlements are not taxable, and that’s true at the state as well as at the federal level. You don’t have to report such monies on your Form 1040. However, if the jury awarded you punitive damages because the party causing your injury acted in a particularly negligent or reckless manner, you will owe taxes on that amount. Often, the compensatory damages in a personal injury settlement, such as lost wages or medical expenses, are listed separately from any punitive damages, so it is easy to figure out the correct amounts.
A Car Accident Settlement May Be Taxable
If your car accident settlement involved personal injury, that part of the lawsuit settlement isn’t taxable. However, if you received monies for emotional distress and the emotional distress wasn’t directly related to your injuries, you must pay tax on that amount. For example, if the car accident caused you emotional distress in that you now have a panic attack every time you get behind the wheel, that part of the money from the settlement is taxable.
When Compensatory Damages Are Taxable
Compensatory damages are those awarded to a plaintiff to replace something lost. Compensatory damages are taxable when they do not pertain to any sort of injury. That’s the situation if you are awarded such damages in an employment or any other type of court case for back pay or the like.
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