My Insurance Company Gave Me a $6,500 Settlement. Do I Have to Report It to the IRS?

Back in May, my 2013 Toyota Prius was rear-ended by an uninsured driver. It took a few months to get a settlement check from my pay-per-mile company (the slow service was the leading reason I'm switching car insurance companies), but now that the check is in my hand I'm faced with another question -- do I have to report this to the IRS?

Turns out, the question isn't that complicated for most people but could get thorny depending on what "damages" you're seeking compensation for. So if you, like me, received a settlement from a car insurance company this year, let's take a look at when you have to report it on your tax filing.

When your insurance settlement is not taxable income

I'll go ahead and spoil the ending. Most insurance settlements are not considered taxable income, including mine. That includes compensation for damages to property, physical injury, and emotional distress arising from injuries.

To understand why, recall that an insurance settlement has one purpose: to make you whole again. Some event, whether it's a car accident or a weather disaster, has taken something from you and left you in a different financial situation. The compensation from your insurance company exists to bring you back to your former state. You're not any wealthier than before, at least not in the eyes of the IRS.

That's an important point. The IRS taxes income, which is money that theoretically increases your wealth. If you sell a stock above what you paid for it, you're wealthier and the IRS will levy a capital gains tax, unless you're investing in an IRA or 401(k) account. But if you're getting a $6,500 settlement to fix your Prius whose damages have been appraised as such, you're just replacing what was lost.

When your insurance settlement is taxable

Again, most people won't have to report their insurance compensation as income on their tax filing. That said, there are a few instances when you might have to pay taxes.

One is if your insurance company includes "back pay" in your settlement, which is a payment for lost wages. For instance, if you make $25 an hour and you miss 30 hours of work, your insurance company might pay you $750 for the hours you missed. This is money you would have earned and therefore would have paid taxes on. In this case, your insurance company might send you a 1099 form for the back pay and you would have to report it on your tax return as "other income."

You might also pay taxes if your settlement included punitive damages. As the name suggests, punitive damages aren't compensatory, meaning they don't redress damages or injuries, but rather exist as a punishment in cases of extreme negligence. For example, a drunk driver who causes an accident may have to pay punitive damages to victims in addition to compensation for injuries or damaged property. In this case, you would include the punitive payment as income in your tax filing.

When in doubt talk to a tax advisor

All in all, if you're compensated for an injury or accident, your insurance settlement is probably not taxable. When in doubt, however, don't hesitate to reach out to a tax advisor, especially if your settlement isn't straightforward or includes numerous parts to your payment. Many tax pros can field questions over email and help you estimate how much you need to set aside for taxes. You likely won't need professional tax help for most insurance settlements, but it doesn't hurt to ask if you already have a tax pro.