Do You Have to Claim Workers’ Comp Settlement on Your Taxes?
Understand how workers' comp settlements are treated for tax purposes, including which portions may be taxable and the importance of proper recordkeeping.
Receiving a workers’ compensation settlement can provide financial relief after a workplace injury, but it also raises important tax questions. Many wonder whether they need to report their settlement on their taxes and if any portion is taxable. The answer depends on how the settlement is categorized under tax laws.
Understanding which parts of a settlement may be subject to taxation ensures compliance with IRS rules while maximizing benefits.
Key Tax Considerations
Workers’ compensation settlements are generally exempt from federal income tax under Internal Revenue Code (IRC) Section 104(a)(1). These payments replace lost earnings due to a work-related injury rather than serving as additional income. Unlike wages, which are subject to federal income, Social Security, and Medicare taxes, workers’ compensation benefits are typically excluded from these obligations.
However, tax implications can arise if the settlement affects other benefits. A common issue occurs when a workers’ compensation settlement reduces Social Security Disability Insurance (SSDI) benefits, known as an offset. In this case, the portion of the settlement that replaces SSDI benefits may be taxable since the IRS considers it a substitute for taxable SSDI payments.
State tax laws also play a role. While most states follow federal guidelines and exclude workers’ compensation from taxable income, some have specific reporting requirements or exceptions. For example, certain states tax interest earned on delayed settlement payments, even if the principal amount remains tax-free. Knowing state-specific rules helps prevent unexpected tax liabilities.
Components of the Settlement
Workers’ compensation settlements include different types of payments, each with its own tax treatment. Understanding how each component is classified helps determine whether any portion must be reported as income.
Medical Reimbursement
Payments for medical expenses related to a workplace injury are generally not taxable. This includes hospital bills, doctor visits, prescription medications, and rehabilitation services, as long as these expenses were not previously deducted on a tax return.
If medical expenses were deducted in a prior year and later reimbursed through a settlement, the reimbursed amount may be taxable under the tax benefit rule. For example, if a worker deducted $5,000 in medical expenses and later received a $5,000 settlement for those costs, that amount would be taxable in the year it was received.
Settlements may also include payments for future medical expenses. These remain tax-free if used for medical care. However, if a portion is allocated to non-medical purposes, such as compensation for emotional distress unrelated to physical injury, that amount may be taxable. Keeping detailed records of medical expenses and reimbursements ensures proper tax reporting.
Wage Replacement
Workers’ compensation settlements often include payments to replace lost wages due to an injury. These benefits are generally tax-exempt under IRC Section 104(a)(1), whether received as ongoing payments or a lump sum.
If a worker also receives unemployment benefits while collecting workers’ compensation, the unemployment payments remain taxable. The IRS considers unemployment compensation taxable income, even if the worker is unable to work due to an injury.
Structured settlements that provide periodic wage replacement payments do not change the tax treatment. Whether received in installments or as a lump sum, these payments remain tax-free as long as they are classified as workers’ compensation benefits.
Additional Damages
Some settlements include payments beyond medical reimbursement and wage replacement, such as compensation for pain and suffering, emotional distress, or punitive damages. The tax treatment of these payments depends on their classification.
Compensation for pain and suffering related to a physical injury is generally not taxable. However, if the payment is for emotional distress without a physical injury, it may be considered taxable income. For example, if a worker receives $10,000 for emotional distress caused by a workplace incident but has no physical injury, that amount is subject to income tax.
Punitive damages, awarded to punish an employer for negligence or misconduct, are always taxable. These payments must be reported as “Other Income” on a tax return and may be subject to higher tax rates depending on total income for the year.
Interest earned on delayed settlement payments is also taxable. If a settlement includes interest due to late payment, the interest portion must be reported as taxable income.
When Settlement Amounts May Be Taxable
While most workers’ compensation settlements are not subject to federal income tax, certain circumstances can make portions of the settlement taxable.
If a settlement includes reimbursement for legal fees, the taxability depends on whether the fees were previously deducted as a business expense or under itemized deductions. If legal expenses were deducted in a prior year and later reimbursed, that amount must be reported as income.
Another factor is the inclusion of retirement benefits within the settlement. If a worker receives compensation categorized as a retirement pension or disability retirement rather than workers’ compensation, this income may be taxable. Disability pensions are often treated as taxable income unless the worker qualifies for specific exclusions under IRS rules. If a worker transitions from workers’ compensation benefits to a disability pension, the tax treatment changes, and the payments may become subject to income tax.
Structured settlements, where payments are spread out over multiple years, can also create tax complexities. While the principal amount remains tax-free, any portion that accrues interest over time could be taxable. If the settlement is invested in an annuity, annuity payments often include both a return of principal and taxable interest.
Recordkeeping and Reporting
Maintaining accurate records is essential when handling a workers’ compensation settlement, especially if portions of the payment may have tax implications. Settlement agreements should be retained indefinitely, as they outline the allocation of funds and serve as evidence if tax questions arise. Correspondence with insurance companies, attorneys, and medical providers should also be kept to substantiate claims.
Bank statements and deposit records help track how settlement funds are received and used. If any portion is invested or placed into an interest-bearing account, records of earnings must be maintained, as interest income is taxable. Financial institutions typically issue Form 1099-INT for interest exceeding $10 in a calendar year, and failing to report this could result in penalties.
If legal fees or other deductible expenses are paid from the settlement, retaining receipts and invoices supports accurate reporting when filing taxes. Proper documentation ensures compliance with IRS regulations and prevents issues in the event of an audit.