There are all types of insurance settlements. You might receive an insurance settlement from a life insurance company if you're the beneficiary of a policy. If you have a car accident and the company pays you money for your loss, you also receive an insurance settlement. The same is true if you sue a company or individual and their insurance company gives you money. All of these are settlements but the tax you pay varies.
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You pay no tax on a life insurance settlement unless it includes some type of interest in the payment, such as interest on dividends, and then you only pay tax on the interest. In some states, life insurance is not included in the estate for inheritance or estate tax purposes. However, the funds remain in the estate for federal estate tax purposes.
From Your Own Auto and Homeowners Insurance
If you've had an accident or a fire and the insurance company gives you a settlement to cover the cost of your loss, you don't pay tax on that settlement. Since losses are tax deductible if there is no insurance, the settlement is simply offsetting that loss and putting you back to the financial position you were in before the loss.
Settlement for Lost Wages
If you have a car accident and the settlement included funds for lost work time, you pay taxes on that money. If you had worked, you would have paid tax on the funds received. The difference is that you pay no Social Security tax on the money. The same is true if you sue a company and the money replaces lost wages due to injury or discrimination.
You only pay tax on disability insurance if someone paid the premium for you, such as employer or if you tax deducted or used pretax dollars for the premium, such as in a Section 125 program at work. The Internal Revenue Service wants taxes on one end or the other, so it's best to pay for disability insurance premiums with after-tax dollars.
Pain and Suffering vs. Injury
If the money is for future medical bills because of an injury from an accident, you probably won't have to pay tax on it. However, if you suddenly develop mental problems because of post-traumatic stress syndrome, expect to receive a tax bill on any settlement. In the case of Murphy and Leveille, Appellants v. IRS and U.S.A., the court proclaimed that funds received by Murphy for mental anguish were taxable. This was in contrast to earlier decisions that ruled the funds nontaxable.
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