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Are Insurance Settlements Taxable?
by
JG Wentworth
•
March 26, 2024
•
5 min
Insurance settlements provide financial relief to individuals in the event of unforeseen events such as accidents, natural disasters, or loss of property. However, many recipients of these settlements wonder whether these payouts are subject to taxation.
If you find yourself receiving an insurance settlement, it’s crucial to understand the tax implications, including which types of settlements are taxable, which are tax-free, and other important considerations.
Types of Insurance Settlements
Insurance settlements can take various forms, the most common of which are:
Medical Malpractice: Any act or omission by a physician during treatment of a patient that deviates from accepted norms of practice in the medical community and causes an injury to the patient.
- Personal Injury: An injury to a person’s body or mind, as the result of an accident.
- Wrongful Death: When a person’s death is caused by a negligent or intentional act of a wrongdoer.
Additional types of insurance settlements include:
Property damage settlements.
- Life insurance settlements.
- Disability insurance settlements.
- Business interruption insurance settlements.
Each type of settlement may have different tax implications, depending on the circumstances surrounding the settlement and applicable tax laws.
Taxable Settlements
In general, insurance settlements that compensate for lost income or profits are considered taxable income. This includes:
- Compensation for lost wages in personal injury cases.
- Business interruption insurance settlements that reimburse lost profits.
These settlements are subject to federal income tax and, in some cases, state income tax as well.
Tax-Free Settlements
Not all insurance settlements are taxable. Some common examples of tax-free settlements include:
- Compensation for physical injuries or illnesses.
- Reimbursement for medical expenses related to said injuries or illnesses.
- Life insurance settlements paid out upon the death of the insured.
- Settlements for property damage or loss that are equal to or less than the adjusted basis of the property.
- These settlements are typically excluded from gross income and are not subject to federal or state income tax.
Structured Settlements
In some cases, insurance settlements may be paid out in the form of a structured settlement, which provides periodic payments over time rather than a lump sum.
Structured settlements may offer financial advantages, as the income received from these settlements is often tax-free if it meets certain criteria outlined in the tax code.
- Compensation for Physical Injuries or Illnesses: Structured settlements that compensate for physical injuries or illnesses are generally considered tax-free under Section 104(a)(2) of the Internal Revenue Code. This provision exempts damages received on account of personal physical injuries or physical sickness from gross income for tax purposes.
- Court Exemption: Because the transfer of the rights to untaxed settlement payments goes through a court, these lump sum payments will typically retain tax-free status.
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Reasons Why Some Structured Settlements Are Taxable
While most structured settlements are non-taxable, there are a few exceptions to consider.
- Non-Qualifying Damages: Structured settlements that compensate for non-physical injuries, such as emotional distress, defamation, or punitive damages, may be subject to taxation.
- Taxable Investment Earnings: While the principal amount of a structured settlement is typically tax-free, any investment earnings or interest earned on the settlement funds may be subject to taxation. Recipients should be aware of the tax implications of investment earnings generated by their structured settlement.
- Higher Tax Bracket: If a lump sum payment places the recipient into a higher tax bracket, then they may be subject to taxation accordingly.
Why Would Individuals Opt for a Lump Sum?
In some cases, individuals who are entitled to a structured settlement may opt to exchange it for a lump sum payment through a third party. The most common motivation for this is simple: the need for cash sooner than later.
- Home repairs.
- Debt repayment.
- Investment opportunities.
- Unexpected medical expenses.
- Life chances (marriage, childbirth, etc.).
- In these circumstances, a lump sum of cash may be very beneficial in order to address urgent financial needs.
Understanding Your Financial Situation
In conclusion, the tax treatment of insurance settlements depends on various factors, including the type of settlement received and the purpose for which it is paid. While some settlements are taxable as income, others are tax-free under certain circumstances.
If you’re receiving a settlement, it’s essential to understand your tax obligations and consult with a tax professional if you have questions or concerns. By staying informed and complying with tax laws, individuals reap the benefits of their settlements and avoid potential penalties.
In the event you find yourself with urgent financial needs in which exchanging your structured settlement payments for an immediate lump sum would be beneficial, then JG Wentworth is here to help you through that process.*
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* Sales of Structured Settlement and Lottery Payments are subject to Court Approval and other conditions which can take 60-90 days to complete. Annuity payment sales are also subject to certain conditions. All transactions are at our sole discretion.
The information is provided for educational and informational purposes only. Such information or materials do not constitute and are not intended to provide tax, accounting, or legal advice and should not be relied on in that respect. We suggest that You consult an attorney, accountant, and/or financial advisor to answer any financial or legal questions.