Insurance payouts can help keep us afloat in the worst of circumstances. Whether you’ve had an accident on the job, or somebody dinged your ride on the road, the claimable funds help put things right again — or as close to “right” as is possible!
But you’re not alone if you don’t really think about the finer points of your insurance policies until you need to make a claim, at which point, you may have a few questions about how it all works, questions like… will I have to pay income tax on my payout?
Let’s discuss the matter in more detail.
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Are Insurance Payouts Subject To Tax?
Good news! For the most part, insurance payouts are 100% taxless sums — hooray! Yep, if you’ve recently had a payout or are in the process of making a claim, tax isn’t typically something you’ll need to worry about, and the reason why is quite poetic really.
Why Aren’t Insurance Payouts Taxable?
The whole idea of income tax is that you give the state a little slice of your financial pie every time you become wealthier, i.e. when that monthly paycheck hits your desk.
We’ve got the money to give, we all chip in, the nation prospers, and as a result, we too prosper.
The concept of receiving an insurance payout, on the other hand, is slightly different.
In essence, an insurance payout is reparative, meaning its core function is to restore or help ease the burden of something lost.
In other words, when you have a viable claim, it’s because you’ve experienced something that has detracted from your situation, wealth, or well-being, and the insurance payout is a means of returning you and your finances to your former glory.
So, if, technically speaking, an insurance payout is just making you whole again rather than actually adding to your wealth, it doesn’t fall under the income tax remit, and thus, you don’t have to pay any.
For example, let’s say that somebody rear-ends your car. The insurance payout you get isn’t to buy a Ferrari, but to repair your car to a standard equal to its condition before the accident.
However, to say insurance payouts are never taxed wouldn’t be quite correct, so let’s take a look at some different insurance types and how they fit into our tax system.
Insurance Payouts That Will Not Be Taxed
Property Insurance
When you claim property insurance, much like in our car example from a moment ago, the goal is not to get rich, but to fix or replace something that was broken or taken due to no fault of your own.
In light of this, property insurance is almost never taxable by the state.
It doesn’t matter if you were burgled, somebody crashed into your vehicle, or a natural disaster damaged your property, if you have the appropriate coverage, you’ll get the payout, and the taxman won’t bat an eye.
Medical Insurance
Unlike property insurance which is taxed in certain circumstances (more on that later), medical insurance payouts are never taxed.
This is because the policy provider foots the bill for appointments and procedures with set prices after they’ve taken place.
There’s no way something can be done cheaper — A cast for a broken leg costs what a cast for a broken leg costs, and that’s that.
Furthermore, it’s common for medical insurers to do business with doctors and medical facilities directly, meaning we, the patient, never see the money at any point of the transaction.
If the provider overpays for something due to a coding error, they subtract the difference from the next payout the medical practice requests, thereby squaring things up without the patient ever knowing about it.
Compensatory Insurance
Much like property insurance, the purpose of compensation is to right a wrong, but being that compensatory payouts often pertain to something immaterial, such as trauma or missed opportunities, there is no way to give the issue a definite value.
This, in turn, means that it’s impossible to differentiate between funds that make someone whole again and excess that adds to their wealth.
The general mode of thinking in these scenarios is that the claimant cannot be made whole again, and thus, tax could never apply to the payout received.
Life Insurance
The principles of life insurance payouts are relatively similar to those of compensatory payouts in that you can’t put a price on the life of a loved one, therefore funds are nigh on impossible to tax as income.
Insurance Payouts That May Be Taxed
Property Insurance (Excess)
Sometimes, you’ll be able to remedy your situation with less than the sum of the payout.
This could be because the policy provider overpaid, but it’s also sometimes that the claimant finds a way to cut costs.
For instance, you may find a way to fix your damaged property yourself.
You still have to buy materials, but labor costs are completely wiped from the equation, leaving you with some walkin’ around money after the fact.
Being that the property has been restored, bringing your wealth and wellbeing back to where it was before the damage was incurred, the remaining funds count as additional wealth, are classed as income, and should be taxed accordingly.
Life Insurance (Interest & Estate-As-Beneficiary)
While the life insurance itself might not be taxed, any interest it accrues in your account is classed as income and will be taxed.
Taxable interest accumulation begins at the point of death.
Furthermore, if the deceased allocated their estate as the beneficiary, rather than an actual person, the inheritors of the estate could be subject to federal estate tax.
State-enforced inheritance tax may also apply depending on place of residence.
Disability Insurance
Being that disability insurance replaces a job as a primary source of income, in most cases, it must be declared as such when filing your tax return.
The same is true of both short- and long-term claims.
Punitive Damages
Sometimes insurance claims can get messy and wind up in the courtroom. In certain instances, a judge may decide that as punishment, the defendant must pay punitive damages to the aggrieved party.
These fees will be taxed as regular income, but any other payout, whether it’s to cover medical bills or property damage, will not be taxed.
Final Thoughts
There you have it. Insurance payouts are rarely taxable, which I’m sure is a load off your mind, but do be wary, as there are certain situations in which you will be obliged to pay tax on a payout.
