Do They Take Taxes Out of Workers’ Compensation?

When an unexpected workplace injury or illness occurs, workers’ compensation benefits can provide much-needed financial support. A common question is whether these benefits are subject to taxation. Understanding the tax implications of workers’ compensation is important for managing your finances during a challenging time. This article clarifies the general tax treatment of these benefits and outlines specific situations where they might become taxable.

General Tax Treatment of Workers’ Compensation Benefits

Generally, workers’ compensation benefits received for personal physical injuries or sickness are exempt from federal income tax. This exclusion applies regardless of whether the benefits are paid as a lump sum or through regular periodic payments. The Internal Revenue Service (IRS) states in its guidance that amounts received under a workers’ compensation act for an occupational sickness or injury are fully tax-exempt.

This tax exemption covers various types of benefits provided by workers’ compensation programs. These typically include payments for medical expenses, compensation for lost wages (temporary or permanent disability), and benefits for permanent impairment or disfigurement. The rationale behind this exclusion is that these payments are intended to compensate for a personal injury or sickness, rather than representing earned income. Death benefits paid to survivors under workers’ compensation acts are also generally exempt from taxation.

When Workers’ Compensation Benefits May Be Taxable

While workers’ compensation benefits are largely non-taxable, certain circumstances can lead to a portion of these benefits becoming subject to federal income tax. These exceptions often arise when workers’ compensation interacts with other benefit programs or includes specific types of payments. Understanding these scenarios is important for accurate tax planning.

One common situation involves the interaction with Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI) benefits. If you receive both workers’ compensation and SSDI or SSI, your Social Security benefits may be reduced, an adjustment known as an “offset.” When this offset occurs, the portion of your workers’ compensation benefits that effectively replaces the reduced Social Security or SSI benefits may become taxable. This happens because the combined benefits generally cannot exceed 80% of your average earnings before your injury.

Another scenario where taxability can arise is with third-party settlements. If a workers’ compensation settlement includes amounts specifically designated for punitive damages, these amounts are generally taxable, even if related to a physical injury. Compensation for emotional distress not directly tied to a physical injury may also be taxable.

Any interest received on a workers’ compensation award is typically considered taxable income. Additionally, if you return to work on light duty while still receiving workers’ compensation, the wages earned from that light duty work are taxable income.

Reporting Workers’ Compensation Benefits on Your Tax Return

Even though most workers’ compensation benefits are not taxable, understanding how they are handled on your tax return is crucial. Generally, you will not receive a Form W-2 or Form 1099-MISC for non-taxable workers’ compensation benefits from the payer.

If your workers’ compensation benefits are entirely non-taxable, you do not need to report them as income on your Form 1040. If a portion of your benefits becomes taxable, such as due to an SSDI offset or interest on an award, you will need to report that taxable amount. For taxable Social Security benefits, you should receive a Form SSA-1099, which will indicate the amounts to report. Taxable interest income is typically reported on your tax return.

It is always advisable to maintain thorough records of all workers’ compensation payments, medical expenses, and any related documentation. These records can be important for verifying your income or eligibility for other programs, and they provide essential support in case of an inquiry from the IRS.