Is Workers Compensation Taxable?

Quick Answer

Workers’ compensation benefits are not taxable income. For federal income tax purposes, benefits that are awarded under a workers’ compensation act or statute due to work-related sickness or injury are fully exempt from tax.

What Is Workers’ Compensation?

Workers’ compensation is a form of employer-provided insurance that offers financial support to employees who suffer work-related injuries or illnesses. The purpose of these benefits is to help cover:

Lost wages
Medical expenses
Rehabilitation services
Short-term or long-term disability
Survivor benefits for families of workers who pass away due to a workplace injury

Is Workers’ Comp Taxable at the Federal and State Level?

Many injured workers worry that their workers’ comp benefits will get taxed at either the state or federal level. As mentioned previously, most individuals receiving benefits have little to worry about when it comes to taxes on their payments.

Federal Level Taxes for Workers’ Comp

Workers’ comp is not taxable as federal income under the IRS Code Section 104(a)(1). You will never have to worry about the IRS or the federal government requiring any sort of tax reporting for your workers’ comp benefits. In fact, your workers’ comp benefits should not appear anywhere on your Form 1040, and the insurance company will not send you any sort of W2 or 1099. All types of benefits are excluded from tax reporting, so it does not matter if you got a lump sum, weekly payments, vocational rehab, medical reimbursement, etc.

State-Level Taxes for Workers’ Comp

This is where tax law for workers’ comp can get slightly tricky. Across the board, you generally do not have to worry about taxes at the state level either. States that do not have any form of income tax already mean workers’ benefits are already exempt. States that do have taxes on income will still follow the federal model and exclude workers’ comp benefits.

However, state laws always differ. While it is not possible to go into the nuances of every single state and how tax laws on workers’ comp may work in specific scenarios, generally speaking, there is no real issue to worry about. Still, if you are concerned that your unique circumstances may cause some sort of taxation on your benefits, it is best to contact a workers’ comp lawyer to help you understand what taxes you may need to owe.

When Workers’ Comp May Become Taxable

There are several instances when your workers’ comp benefits may create a unique tax situation:

Receiving Social Security Disability (SSD) Benefits – If you are currently receiving SSD benefits in tandem with your workers’ comp, then the combined benefits amounts cannot exceed 80% of your average current earnings. If this threshold gets exceeded, it is possible that up to 85% of your SSD benefits will get taxed.
Receiving Retirement Benefits – Similar to receiving SSD benefits, if your workers’ comp and retirement payments exceed the thresholds set by your state, up to 85% of your retirement benefits could get taxed.
Interest on Payments – If your workers’ comp payments were delayed and accrued interest, you will likely have to pay tax. However, the taxed amount is only the interest accrued before payments began. Your main benefits will remain tax-free.
Penalties Paid By the Employer – If you received rewards for penalties paid by your employer for the accident that caused your injury, that reward will be taxed. Remember, any penalties are considered under the law as payments made to you outside of the injury you suffered. Thus, it is possible the IRS will treat it as taxable income.

Remember, broadly speaking, workers’ comp does not get taxed. However, if you receive workers’ comp and other benefits or awards, there may be some tax implications; however, that does not mean workers’ comp directly gets taxed. More so that workers’ comp in conjunction with other benefits can complicate how much your benefits will be and how the tax landscape will look.

What Happens If I Return to Work?

If you fully return to work, then your workers’ comp benefits will end, which would make this question irrelevant, as you would no longer have any benefits that would get taxed in the first place. If you return to work in a partial capacity, then your workers’ comp benefits would get reduced to offset the wages you earn. Even partial payments of workers’ comp will not get taxed, but whatever wages you are now making will.

Common Tax Mistakes to Avoid with Workers’ Comp

Here are several common tax mistakes you should avoid with workers’ comp:

Do not put your workers’ comp benefit amounts anywhere on your tax return. Erroneously putting the benefits you received on your tax return as taxable income will result in you overpaying at tax time.
Keep an accurate record of what benefits you are receiving. If you are receiving multiple benefits from different sources (workers’ comp, SSD, etc.), keep track of all the sources and their potential tax implications. This helps you at tax time ensure that what needs to get taxed gets taxed and what does not remains untouched.
Do not forget about taxes on interest for your workers’ comp payments. Interest paid to you is not exempt, and failure to report it can lead to penalties.
If you deducted expenses from your tax return the year prior and are now receiving workers’ comp benefits, be sure to report any medical reimbursement you received following the tax benefit rule.

Most of these tax mistakes are easily avoidable, but still many injured workers become victims to these pitfalls. Always be thorough during tax time and keep all of your documents and receipts organized for when it comes time to file.

Are There Any Exceptions to the Tax-Free Rule?

If you’re receiving both workers’ compensation and SSDI or SSI, the workers’ compensation offset rule may apply. This rule says that your combined SSDI and workers’ comp benefits cannot exceed 80% of your average earnings before your disability began. If the combined amount is over that 80% threshold, the Social Security Administration (SSA) may reduce your SSDI benefits to stay within the limit.

While workers’ comp itself is not taxed, the portion of SSDI reduced by the offset is considered taxable. In other words, while your workers’ comp payments remain tax-free, they can indirectly cause part of your SSDI benefits to be taxed.

Also, if your workers’ compensation benefits or settlement are delayed and you receive interest on that delay, the interest portion may be taxable. The IRS may treat that interest as taxable income, even if the core settlement remains tax-free. This can vary by state and by how the settlement is structured.

What About Workers’ Compensation Settlements?

Most workers’ compensation settlements, including lump-sum settlements, are not taxable if they are compensation for a workplace injury or illness under state law. However, there are a few situations where portions of a settlement might be taxed:

If part of your settlement includes wage replacement during a period when you were also receiving SSDI, that portion may trigger the offset mentioned earlier.

Suppose your settlement includes compensation for something unrelated to the injury (such as a contract dispute or back pay for unrelated work issues). In that case, that portion may be treated as taxable income.
Structured settlements, which pay out over time, are generally tax-free, unless a portion includes interest, which may be taxed.

To preserve the tax-free status of your settlement, it’s crucial that the settlement agreement clearly states that the funds are for a workplace injury or illness.

Do I Need to Report Workers’ Compensation on My Tax Return?

As a general rule, no, you do not need to report your workers’ compensation benefits on your tax return. Since you are not required to pay income tax on these benefits, there is no need to report them. However, tax experts do advise that retirement plan benefits can be taxed if either:

You retire because of an occupational injury or sickness.
Your workers’ comp payments lower your Social Security or railroad retirement benefits.

Additionally, you may have to report your workers’ compensation as income if:

You received the payments as compensation for an injury.
You made prior deductions of related medical expenses.

Are There Exceptions Where a Workers’ Compensation Settlement Could Be Taxed?

Although most workers’ compensation is exempt from taxes, there are exceptions to this rule if an individual receives other forms of income while also receiving workers’ comp payments. According to IRS rules, other types of income that you receive simultaneously with workers’ comp have to be reported and you must pay taxes that were not already withheld. These include:

Retirement Benefits

An injured worker may accept a workers’ comp settlement but also retire due to the workplace injury or illness they suffered. Those retirement benefits that are based on age, the amount of work the employee did, or employee contributions are taxable. Even though your injury or illness led to your retirement, these benefits are not considered part of your workers’ comp settlement.

Return to Light-Duty Work

The worker may receive workers’ comp but later regain the ability to perform light-duty work tasks and earn at least a little extra income. If the worker takes such a position, they will need to pay taxes on the money they earn. The worker will still not be taxed on their workers’ comp payments.

Social Security Disability Insurance (SSDI)

Injured workers with qualifying disabilities may receive SSDI, but combined with workers’ compensation their total benefits cannot exceed 80% of their average monthly income. If the combined payments exceed this threshold, the injured worker is subject to an offset.

An offset will be deducted from the worker’s SSDI benefits to lower the combined total (SSDI plus workers’ comp) back to the 80% mark. This offset amount will also be taxable. However, other complex tax rules may affect whether the offset is even an issue.

Talk to Pond Lehocky to learn more.

What About Interest Paid?

Some injured workers accept a structured settlement that pays them money over time. Although the original settlement amount is not taxable, any interest that is earned on the money will be. Along with this are interest gains on the original settlement amount.

The government views interest and other gains on the original settlement amount to be distinct forms of income. So while the workers’ compensation benefits themselves remain tax-free as per the standard rule, the interest is separate and apart from that money and needs to be reported on the worker’s income tax return.

Is a Lump-Sum Workers’ Comp Settlement Taxable?

Lump-sum workers’ compensation settlement payments are popular options for those who want a significant amount of money upfront without having to wait for periodic payments or continue dealing with the hassle of a workers’ comp claim. In most cases, a worker will not have to pay federal taxes on this settlement amount.

There are, however, potential limitations to this rule. For instance, if the injured worker earns additional income or benefits (like the ones mentioned above), then taxes on those wages will accrue. Also, some states may tax you on the settlement amount. Our legal team represents workers’ comp cases in all 50 states, so let us advise you of any state tax nuances that may apply to your benefits.

How Is a Workers’ Compensation Settlement Calculated?

Since workers’ comp settlements are so popular, it helps to understand how the amount of money is calculated. Various factors are taken into account when the insurance company determines how much of a workers’ compensation settlement to offer. Among these factors are:

The amount of the injured worker’s lost wages
How much the employee had earned before suffering the injury
The worker’s medical condition after the injury
Present and future medical costs the worker will reasonably be expected to incur
The worker’s impairment rating (a percentage that represents the loss of the employee’s overall bodily function affecting their ability to work)
The worker’s educational history
How much it would cost to retrain the employee for a different position if they are unable to return to their previous one because of their injury
The applicable state workers’ compensation laws

It is important to note that you can negotiate your final settlement amount with the workers’ comp insurance company, but it is strongly recommended that you have legal counsel representing you during these discussions. Talk to our experienced team to assist with your settlement so you receive the amount you deserve.

How Long Does It Take to Receive a Workers’ Comp Settlement?

If you’ve been injured on the job, you most likely want to receive a fair amount of workers’ compensation money that will help you pay your bills, replace income, provide for your family, and move on with your life. Naturally, you want to know how long this process will take. Although every workers’ comp case is different and timelines may vary, an injured worker should expect their claim to last anywhere from 12 to 18 months.

Settling may only take 12 to 14 months if the worker’s injury does not lead to a permanent disability if they have no attorney representing them, and if they do not negotiate with the insurance company. However, this may result in you receiving less than the money you deserve. Conversely, some factors that may extend the timeline include the insurance company’s resistance to settling with you and any appeals that are taken.
We recommend retaining a knowledgeable attorney to help you better understand the timeline and to expedite the process as much as possible.

When Should I Speak with an Attorney About Workers’ Comp?

You should consult a workers’ compensation attorney if:

You’re negotiating a settlement and want to protect the tax-free status of your benefits.
You’re receiving SSDI and want to understand how the offset may impact your taxes.
Your claim has been denied, delayed, or undervalued.
You’re unsure about your tax responsibilities or documentation.

An experienced attorney can help ensure your benefits are maximized and protected—financially, legally, and medically.

Talk to a Lawyer if You Are Experiencing Tax Issues Related to Workers’ Compensation

Every injured worker simply wants a fair shake from the workers’ compensation system and to better understand their rights. But to protect their best interests, they also need to understand the potential tax implications that come with their decision to accept a settlement, retire, take on additional work, and other scenarios.

If you were hurt in a workplace accident and want to know more about what to expect from workers’ compensation, then it is time to speak with dedicated legal counsel. That is where the attorneys of Pond Lehocky Giordano come in. Contact us to get started or to ask questions about workers’ comp benefits.