Do I Pay Taxes on a Workers’ Comp Settlement?

Understanding the tax implications of a workers’ compensation settlement is a common concern after a workplace injury. Workers’ compensation is a form of insurance providing wage replacement and medical benefits to employees injured in the course of employment. When a settlement is reached, questions often arise about whether these funds are subject to federal or state income taxes. This article clarifies the general tax treatment of workers’ compensation settlements and related payments.

Tax Treatment of Workers’ Compensation Settlements

Workers’ compensation settlements are generally not considered taxable income under federal law. This principle is rooted in Internal Revenue Code Section 104, which specifically excludes from gross income “amounts received under workmen’s compensation acts as compensation for personal injuries or sickness.” The exclusion applies whether the benefits are received as a lump sum or as periodic payments.

The rationale behind this tax exemption is that workers’ compensation benefits are intended to compensate individuals for physical injuries or sickness. These payments are meant to make the injured worker “whole” again, rather than representing a gain in wealth. Most state laws align with this federal guideline, further solidifying the non-taxable status of these settlements across the United States.

This tax-exempt status helps injured workers retain more of their settlement to cover costs associated with their injury and recovery. It acknowledges the financial limitations that can arise when an individual is unable to work due to an occupational injury or illness. The exclusion also extends to benefits paid to survivors of a deceased employee under a workers’ compensation act.

The Internal Revenue Service (IRS) consistently maintains that these benefits are fully exempt from tax if paid under a workers’ compensation act or a similar statute. This long-standing policy has remained consistent through various tax policy changes. Therefore, for the vast majority of injured workers, a workers’ compensation settlement does not need to be reported as income on their federal tax return.

When a Workers’ Compensation Settlement May Be Taxable

While workers’ compensation settlements are generally tax-exempt, certain components or circumstances can make a portion of the settlement taxable. Payments that are not directly for physical injuries or sickness may be subject to taxation.

Punitive damages, which are awarded to punish a wrongdoer rather than to compensate for actual losses, are always considered taxable income. This applies even if they arise from a physical injury case, as their purpose is not to restore the injured party but to penalize the defendant. Similarly, any interest accrued on a workers’ compensation settlement amount while the case is pending or before disbursement is taxable. This interest is viewed as income earned, separate from the compensation for injury.

Compensation for emotional distress can also be taxable if it is not directly related to a physical injury or sickness. For example, if a settlement includes funds solely for emotional distress not stemming from a physical harm, that portion would typically be taxed. However, if emotional distress is a direct consequence of a physical injury, such as anxiety following a car accident that caused physical harm, then the compensation for that emotional distress generally remains non-taxable.

Another scenario involves the “tax benefit rule.” If an individual previously deducted medical expenses related to their injury on a prior year’s tax return and then receives reimbursement for those expenses through the workers’ compensation settlement, that reimbursed amount may become taxable. This rule prevents a double benefit, where a deduction is taken and then the expense is later covered by a tax-free payment.

Other Related Payments and Tax Considerations

Beyond the workers’ compensation settlement itself, an injured worker might receive other types of income that have distinct tax implications. Understanding these can help in managing overall financial health during recovery.

Unemployment benefits, for instance, are fully taxable income at the federal level. If an injured worker receives unemployment compensation while out of work, these payments must be reported on their federal income tax return. While federal taxation is consistent, state taxation of unemployment benefits can vary by state.

Social Security Disability Income (SSDI) benefits can also be subject to federal income tax, though many recipients do not pay taxes on them. SSDI benefits become taxable if a recipient’s total income, including half of their SSDI benefits plus all other income, exceeds certain thresholds based on filing status. For example, a single filer might see a portion of their SSDI taxed if their income exceeds $25,000, with up to 85% of benefits potentially taxable at higher income levels.

In situations where an individual receives both workers’ compensation and SSDI, an “offset” may occur, reducing SSDI benefits if the combined total exceeds a certain percentage of the worker’s pre-injury earnings, typically 80%. If SSDI benefits are reduced due to this offset, the amount of the SSDI reduction that is attributable to workers’ compensation may still be considered taxable as if it were SSDI. However, Supplemental Security Income (SSI) benefits, which are needs-based, are generally not taxable.

Legal fees incurred in pursuing a workers’ compensation claim are generally not tax-deductible for the injured individual. Under current tax law, personal legal expenses, including those related to personal injury lawsuits, are typically not deductible. This differs from legal fees incurred for business purposes, which may be deductible.