Workers’ comp wage benefits are usually not a tax liability unless you also get other disability payments. Here’s what you should know.
Your workers’ comp wage benefits are generally not subject to state or federal taxes. But there is an exception if you’re also getting other disability benefits.
The exception says that your workers’ comp payments may be taxable if you’re also receiving Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI). The value of your combined benefits must exceed a certain threshold for taxes to apply.
Tax laws are complicated and each person’s financial situation is unique. Consult a tax professional to determine if your disability benefits qualify as taxable income.
Workers’ Comp is Generally Not Taxable
The general rule is that your workers’ comp benefits are not taxable at the federal or state level.
Recent Internal Revenue Service (IRS) rules state:
“Amounts you receive as workers’ compensation for an occupational sickness or injury are fully exempt from tax if they are paid under a workers’ compensation act or a statute in the nature of a workers’ compensation act.”
While workers’ compensation payments are considered income, they’re not subject to an income tax and you don’t need to report them on your IRS forms.
If you’re out of work because of your workplace injury but then return to work within the year, you’ll receive both taxable income and non-taxable income. The workers’ comp benefits you’d receive while out of work are non-taxable. However, the wages you earn after returning to work are taxable.
When you’re married, collecting benefits, and you and your spouse file jointly, your workplace injury might reduce your overall tax burden. Since your workers’ comp benefits are non-taxable, you and your spouse will have less taxable income than when you were both working. This could place you in a lower tax bracket.
Tax Liability from Combined Disability Income
Disability benefits may become taxable if you’re getting both workers’ comp benefits and federal disability benefits.
Federal disability benefits include:
- Social Security Disability Insurance (SSDI): Disabled workers may qualify for SSDI if they have paid enough into the Social Security system before they could no longer work.
- Supplemental Security Income (SSI): Low-income workers who don’t qualify for SSDI after a disabling work injury may be eligible for SSI.
In most states, when the total value of the two benefits exceeds 80% of your average earnings before you became disabled, your SSDI or SSI benefits get reduced to offset your workers’ comp. The offset amount may be taxable, if your earning that year are high enough.
Even though workers’ comp is usually tax-exempt, the IRS treats the offset portion as taxable because it would have been if it came from Social Security.
Example: Injured Worker Taxed on Combined Disability Income
Joe suffered a personal injury in the workplace that left him permanently disabled.
As a result of the injury, he receives $1,500 per month in workers’ compensation wage benefits. He also receives $1,500 in SSDI benefits. The two sources of compensation combine for a total monthly value of $3,000.
Before his work-related injury, Joe was making $3,200 per month. Here, Joe’s combined benefits represent approximately 94% of his pre-injury earnings ($3,000/$3,500 = 94%), which exceeds the 80% threshold.
Eighty percent of Joe’s pre-injury earnings is $2,800. This is $200 less than the value of his combined benefits.
Joe’s SSDI payments would then get offset or reduced by $200 so that his benefits fall in line with the 80% amount. Now, Joe would receive $1,500 in workers’ comp benefits and $1,300 in SSDI benefits.
Because of the workers’ compensation offset, $200 of Joe’s benefits becomes taxable (if his total income from the social security benefits is high enough so that the income is taxed).
The reasoning for the tax is that it should apply because Joe would’ve had to pay taxes on the money anyway if he received it as an SSDI payment rather than a workers’ comp payment.
How State Laws Impact Tax Liability
Some states’ workers’ compensation laws apply a reverse offset when a worker receives both workers’ compensation benefits and social security disability benefits.
With a reverse offset, your workers’ comp payment (and not your federal disability payment) is reduced if your income is too high and the combination of your benefits exceeds 80% of your pre-injury earnings.
In these states, workers don’t have to pay any tax on their workers’ comp benefits. However, they will have to pay state tax on their disability benefits if their combined income is high enough.
Tax Liability for Workers’ Comp Lump-Sum Settlements
Some workers’ comp cases are resolved with a lump-sum settlement instead of regular monthly payments. The money from a settlement is typically tax-free. However, the same exception involving SSDI and SSI payments applies.
If a worker settles a workers’ comp case and also receives SSDI/SSI benefits, and the settlement is an amount above 80% of their pre-injury income, then their workers’ comp may get taxed.
Because SSDI converts to regular social security retirement benefits when you reach full retirement age, your tax status may change as well.
There may be a tax liability if both of the following apply:
- The employee’s combined income is high enough they’re paying taxes on social security benefits
- The employee resides in a state that does not impose a reverse offset
If you think you might settle your workers’ comp case for a lump sum, seek legal advice from a workers’ compensation attorney. A lawyer can structure your workers’ compensation settlement to minimize any offsets and reduce your overall tax burden.
For example, an attorney may include language in the settlement agreement so that your lump sum is treated as if it were spread out over your lifetime. You’ll still receive one lump sum payment. However, for tax purposes, the money is treated as if you’ll receive it in smaller amounts monthly or yearly.
Since tax issues are complicated, it’s a good idea to consult with a workers’ comp attorney and a certified tax professional if you’re receiving workers’ comp and other disability benefits. Most attorneys offer a free consultation, while an accountant can help with your tax return. Both are excellent resources to help reduce your overall tax obligations.
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