Are Taxes Taken Out of Workers Comp Benefits?

Workers’ compensation provides wage replacement and medical benefits to employees who suffer injuries or illnesses while performing their job duties. This system supports injured workers by covering related expenses and lost income. This article clarifies the tax implications of workers’ compensation benefits, detailing when these payments are taxable.

General Taxability of Workers’ Compensation Benefits

Workers’ compensation benefits received for a work-related injury or illness are generally not subject to federal income tax. These payments are considered compensation for personal injury or sickness, not earned income. The Internal Revenue Service (IRS) confirms this non-taxable status in publications like IRS Publication 17, stating that amounts received under a workers’ compensation act are fully exempt from tax.

This rule covers various types of benefits, including payments for medical treatment, temporary disability for lost wages, and permanent disability awards. Whether benefits are received as regular payments or a lump-sum settlement, non-taxability applies. This approach helps ensure that injured workers retain the full value of their compensation intended to cover their losses.

Specific Benefit Types and Taxable Exceptions

While medical, temporary disability, and permanent disability payments are generally not taxable, specific situations can lead to indirect tax implications. One instance involves the interaction with Social Security Disability Income (SSDI) benefits. If a person receives both workers’ compensation and SSDI, and their combined monthly benefits exceed 80% of their average earnings before the injury, the Social Security Administration (SSA) may reduce the SSDI payments. This reduction is known as an “offset.”

The amount of the SSDI offset can become subject to federal income tax, even though the workers’ compensation payments themselves remain non-taxable. The rationale is that the offset portion would have been taxable as SSDI if not for the workers’ compensation. For example, if combined benefits total $2,200, exceeding 80% of a $2,500 pre-injury monthly earning ($2,000), SSDI might be reduced by $200, and this $200 could be taxable.

Another scenario involves third-party lawsuits or settlements. If a workers’ compensation claim is part of a larger settlement, such as for pain and suffering or punitive damages, a portion of the overall settlement might become taxable. This can occur even if the workers’ compensation part remains tax-exempt, due to how the total funds are allocated. Additionally, payments for light duty work or other non-injury related reasons after returning to employment are generally considered taxable wages.

Tax Reporting Considerations

Workers’ compensation benefits generally do not need to be reported on federal tax returns unless a specific taxable exception applies. Recipients typically do not receive a Form 1099 or W-2 for workers’ compensation payments, unless they also receive other income like wages from light-duty work or Social Security benefits.

Recipients should maintain thorough records of all workers’ compensation payments received, along with any related medical expenses and financial transactions. This documentation can be helpful for verifying income or eligibility for other programs. If a recipient is also receiving Social Security Disability benefits or if their claim involves a complex settlement, consulting with a qualified tax professional or the IRS directly is advisable to ensure proper tax compliance. While federal non-taxability is common, state tax rules can sometimes differ.