When it comes to tax, understanding what you’re expected to pay is an important part of managing your finances. So, what happens if a large insurance settlement lands in your account?
Here, we’ll look at whether car accident settlements are usually taxable, why they might sometimes leave you owing a tax payment – and how insurance companies try to prevent that happening.
What is a settlement?
In insurance terms, a ‘settlement’ is an amount of money that’s paid from the insurer to complete any claim. For instance, if your car is written-off and is valued at £11,000, assuming there are no complications or issues, your settlement will be £11,000.
Since settlements have the potential to be significant sums of money, it’s not unusual for people to get in touch and ask if they need to be declared to HM Revenue and Customs (HMRC).
Are car accident settlements taxable?
Since an insurance payout is directly compensating you for a lost or damaged asset that you already own, it wouldn’t make sense to pay tax on something that’s already taxed at the point of sale.
For example, if you buy a new car for £20,000, £4,000 of that purchase cost is VAT. If that car were written off when you drove it away from the showroom, assuming the insurance valuation is also £20,000 – then you would get back the amount you paid. If this amount was also taxed, HMRC would be making money – and you’d be out of pocket.
Are there exceptions to this rule?
Although it’s likely to be very rare, there are instances when an insurance payout could become taxable – but the way insurance companies work mean this is very unlikely.
All car insurance policies are based around the principle of ‘restitution in full’ – in other words, the maximum amount that will be paid is the full cost of either replacing your car – or putting it back to the state it was in before the accident.
In some cases, repairing a car will actually increase its value – and this could lead a tax requirement. For instance – if you’ve got a car that’s already damaged – and an accident causes more damage, a repairer with generally just be able to put the car back to its factory state, and not simply repair half the damage. In this case, getting the car back to its showroom condition would involve what insurance companies call ‘betterment’.
Betterment essentially means that the policyholder is in a better position after the payout than they were before. Since this isn’t the offer insurance companies make, they will do everything possible to avoid this – including sometimes recouping what they decide is the betterment amount.
For example – your car has a damaged rear bumper, and as a result, it’s worth £2,000. When you stop at a roundabout, someone bumps the back of your car again, further damaging the bumper – but this time the bumper needs to be completely replaced. The insurance company pays for the work to be done – and, since your car’s now in good condition with a new bumper again (better than before), it’s now valued at £2,250 - £250 more than before. Insurers often refer to this as a ‘betterment amount’.
Chances are, your insurance company will seek to recoup that betterment amount from you, although if they don’t – you’ve essentially made a profit from the insurance payout – which would be a taxable income based on HMRC guidelines.
Again, insurance companies are not in the habit of paying more than they have to for work that needs to be done – but it can happen, so it’s worth talking to your accountant if you find yourself in this situation – or seek advice directly from HMRC.