How an Insurance Class Action Settlement is Taxed

Getting a monetary settlement from an insurance company as a result of a class action lawsuit isn't necessarily pennies from heaven. The money carries tax consequences that you'll need to address when you prepare your annual income tax return.

If you have any questions on how to treat your particular settlement proceeds, it's best to ask your tax consultant or accountant. But here are some general guidelines on what to do when it's time for your annual report to Uncle Sam.

Ordinarily, any income you receive is taxable. (In the insurance world, an exception to this is the proceeds of a life insurance policy to which you're a beneficiary.)

Policyholders eligible for compensation in a class action lawsuit may be offered several options. For instance, Prudential Insurance Co. offered three "relief choices" to policyholders eligible for its 1997 class action settlement. The choices included a refund of premiums (with interest) and two types of "basic claim relief." There could be taxable money involved in each choice.

If you opt for a return of premium with interest, the premium is not subject to taxes, but the interest would be. For other settlement options, distributions from a life insurance policy are not taxable until you've received more money than you paid in premiums. Any amount above that is taxed at the ordinary income rate.

You'll need a Form 1099

If you receive insurance lawsuit settlement money, you'll need an Internal Revenue Service (IRS) Form 1099 that shows the amount of money you received and from whom. There are several types of 1099 forms that report on earned gross income (money from which taxes have not been deducted).

You might get a Form 1099MISC, which applies to miscellaneous income. A 1099MISC shows the total amount you received, so look for an accompanying letter from the insurer that breaks down how much of your settlement is a return of your premium and how much is interest or other settlement benefits. If that happens and you don't get a letter that breaks out the amounts, you can either figure out yourself what premiums you've paid into the policy or call your insurance company and have them do it for you. Bring this information to your tax preparer.

On the other hand, the insurance company may send you a Form 1099INT, which lists the interest payment of your premium that you received. This interest amount is probably subject to income taxes, and you should bring that form to your tax preparer.

It is up to the insurance company which Form 1099 they will use. For your purposes, it's important that the amount you are awarded is broken down either in a letter from the insurance company or through Form 1099. Be sure you don't pay taxes on your returned premium, because you probably paid that premium with your after-tax dollars. Few of us want to pay taxes on that money twice.

The IRS Form 1099 must be sent out by the company from which you've received income, regardless of what type of income it is, by Jan. 31.