How Does Workers Comp Affect Tax Return?
Clarify the tax treatment of workers' compensation. Learn how these benefits can indirectly affect your tax liability through other income and deductions.
Workers’ compensation is a form of insurance that provides wage replacement and medical benefits to employees who are injured during their employment. These state-mandated programs are designed to offer a financial safety net during a period of recovery. Understanding how these benefits are treated for tax purposes is a common concern for recipients navigating their financial obligations.
Federal Tax Treatment of Workers’ Compensation Benefits
The Internal Revenue Service (IRS) does not consider workers’ compensation benefits to be taxable income. According to IRS Publication 525, amounts received for an occupational sickness or injury are fully exempt from federal income tax if paid under a workers’ compensation act. This exemption applies to wage-replacement checks and payments for medical services.
Because these benefits are non-taxable, they are not reported as income on your Form 1040 tax return. The logic behind this treatment is that the payments compensate for a loss rather than generate new earnings.
This non-taxable status extends to benefits received by a survivor after a work-related death. These payments are also exempt from federal income tax because they are compensatory and not considered earned income.
Exceptions to the General Non-Taxability Rule
In some situations, payments connected to a work injury become taxable. For instance, if you return to work in a limited or light-duty capacity, the salary you receive for these duties is considered earned wages. This income is fully taxable and must be reported on your tax return.
If you retire due to a work-related injury, payments you receive from a pension or retirement plan are taxable. These are treated as retirement income, not workers’ compensation benefits, even if the disability prompted the retirement. Taxability is based on the nature of the plan, not the reason for the withdrawal.
If a delay in your workers’ compensation award or settlement results in interest payments, that interest is taxable income. While the principal amount of the settlement is non-taxable, you must report any interest. The payer will issue a Form 1099-INT detailing the interest paid to you.
Interaction with Other Benefits and Deductions
If you also receive Social Security Disability Insurance (SSDI), the Social Security Administration (SSA) may reduce your payments. This occurs if your combined benefits exceed 80% of your average earnings before you became disabled. This reduction is known as the “workers’ compensation offset.”
The offset amount can cause a portion of your SSDI benefits to become taxable. For example, if your combined benefits are $200 over the limit, the SSA might reduce your SSDI payment by $200. That $200 is then treated as if it were a Social Security benefit for tax purposes and may be taxed depending on your other income.
This interaction does not make the workers’ compensation itself taxable. Instead, it recharacterizes a portion of it, which can make your overall Social Security benefits taxable. The SSA will issue a Form SSA-1099 reflecting this calculation.
You cannot claim a medical expense deduction for any costs paid for or reimbursed by your workers’ compensation plan. If you paid for a medical treatment and were later reimbursed, you cannot deduct that expense. Only out-of-pocket medical expenses not covered by insurance are deductible.
Legal fees related to securing a workers’ compensation settlement are not deductible for most individuals. The Tax Cuts and Jobs Act of 2017 (TCJA) suspended this deduction for tax years 2018 through 2025.