Is Workers Compensation Taxable According to the IRS?

Workers’ compensation is insurance that provides wage replacement and medical benefits to individuals injured during their employment. For recipients, a primary concern is potential tax liability. The Internal Revenue Service (IRS) generally does not consider workers’ compensation benefits to be taxable income, meaning you are not required to pay federal income tax on the payments you receive in most situations.

Taxability of Workers’ Compensation Payments

According to the IRS, amounts received for an occupational sickness or injury are exempt from tax if they are paid under a workers’ compensation act or a similar statute. This applies whether the benefits are paid as a single lump-sum settlement or as periodic payments over time. The exemption covers payments intended to replace lost wages while you are unable to work.

This tax-free treatment also extends to the portion of your benefits designated for medical care. Any amount paid by the workers’ compensation insurance carrier directly to a healthcare provider or reimbursed to you for out-of-pocket medical expenses is not considered taxable income.

The tax exemption is not limited to the injured worker alone. If a work-related injury or illness results in death, any workers’ compensation benefits paid to a survivor, such as a spouse or child, are also non-taxable. The IRS views these payments as a continuation of the tax-exempt benefits the worker would have received.

When Workers’ Compensation Benefits May Be Taxable

While the general rule is that workers’ compensation is tax-free, certain situations can create taxable income. One such instance involves interest payments. If a portion of your settlement or award is specifically designated as interest for a delay in payment, that interest amount is considered taxable income and must be reported to the IRS. The underlying workers’ compensation benefit remains tax-free, but the interest component is treated separately.

Another distinction arises with return-to-work programs. If your employer provides you with a “light-duty” job or another modified role as you recover, the wages you earn from this work are fully taxable. These payments are considered compensation for services performed, not benefits for an injury. Your employer will report these earnings on a Form W-2, just like any other wages.

The source of payment is a determining factor for retirement benefits. If you retire on disability, any benefits you receive from your pension or retirement plan are taxable as retirement income, even if the disability was caused by a workplace injury. These payments are governed by the rules for pensions and annuities, not the rules for workers’ compensation.

Finally, payments for non-physical injuries can sometimes be taxable. Compensation for emotional distress or mental anguish may be considered taxable income if it is not associated with a physical injury or sickness. For these payments to be tax-free, they must be for emotional distress that originates from a physical injury sustained at work.

Interactions with Other Tax Items

The receipt of workers’ compensation can affect other areas of your tax return. If you deducted medical expenses on your tax return in a prior year and are later reimbursed for those same expenses through a settlement, the reimbursement becomes taxable income. You only report as income the amount that gave you a tax benefit, which is the lesser of the reimbursement or the original deduction.

An interaction occurs with Social Security Disability Insurance (SSDI). The Social Security Administration may reduce, or “offset,” your SSDI benefits if you are also receiving workers’ compensation. The combined total of your benefits generally cannot exceed 80% of your average earnings before you became disabled. This offset can create a tax liability, as the IRS treats the workers’ compensation amount that causes the reduction in SSDI as if it were Social Security benefits for tax purposes.

Reporting on Your Tax Return

The non-taxable portion of your benefits for lost wages and medical expenses should not be reported on your Form 1040 or its schedules. Any portion that is taxable, such as interest payments, must be reported on Schedule 1 (Form 1040) on the line for “Other income.”

If a payer mistakenly issues a tax form, such as a Form 1099-MISC, for non-taxable benefits, contact the payer immediately. You should request that they issue a corrected form showing zero taxable income to prevent inquiries from the IRS.