Workers’ Compensation Benefits are Tax Exempt
Workers’ compensation is not taxable. According to the IRS, “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.”
Most workers’ compensation benefits are not taxable at the state or federal levels. Workers’ compensation falls into the same category of non-taxable income as:
- Public welfare fund payments;
- Compensatory (but not punitive) damages for physical injury or sickness;
- Disability benefits that fall under a “no-fault” car insurance policy for loss of income or earning capacity as a result of injury;
- Compensation for permanent loss of limb, loss of physical body function, or permanent disfigurement.
In other words, for federal income tax purposes, workers’ compensation benefits awarded due to a work injury are exempt from tax. Payments to survivors are exempt under the same circumstances.
Exception to the Rule
If an injured worker receives supplemental security income on top of their workers’ compensation, that supplemental income can be taxed. Specifically, there is a small portion of your workers’ comp benefits that can be taxed if you also receive either Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI).
Payments coming from Social Security would be reduced and the difference created by the payment of workers’ compensation would be taxable. Even that has a caveat. Remember the amount you receive matters when it comes to your taxes. However, in most cases, this amount could be small enough to be negligible for taxation.
How and When Workers’ Comp is Taxable
Let’s just start with the most basic question: did the injury occur at work? Remember, workers’ compensation benefits are not ordinarily deemed taxable benefits at state or federal levels. As stated, the exception arises when a person also collects disability benefits through Social Security disability insurance (SSDI) or Supplemental Security Income (SSI).
In these rare cases, the Social Security Administration (SSA) may diminish a person’s SSDI or SSI so that the total amount of benefits between the workers’ compensation and the disability payments stays below a specified threshold. This reduction is called the workers’ compensation offset.
The amount of taxable workers’ compensation is the same amount the SSA reduces in your disability payments.
Thus, if Social Security lowers your monthly SSDI check by $250 due to the workers’ compensation offset, then that $250 of your workers’ comp is taxable.
What About the Federal Threshold for Taxable Income?
Most people who receive workers’ compensation benefits and Social Security benefits don’t have enough taxable income to owe federal taxes. What this means is that even if a portion of your benefits is taxable, it is still unlikely you will owe any taxes. Furthermore, an accomplished workers’ compensation lawyer will be able to structure your workers’ compensation settlement to minimize the offset and reduce your taxable income. So, even if you fall into that rare subset of people who do have a portion of their workers’ comp deemed taxable income, a good attorney can help reduce or eliminate the tax liability on your benefits.
When Does the Workers’ Compensation Offset Apply?
Let’s do the math. If you are receiving both Social Security Disability and workers’ compensation benefits, the combined amount cannot exceed 80% of your average current earnings. Your “average current earnings” are defined as the largest of:
- the average monthly wage used to calculate your benefits
- one-sixtieth of your total wages for your highest-earning five years in a row, or
- one-twelfth of your total wages from your highest-earning year out of the preceding five.
Most states deal with this by lowering your Social Security payments until you no longer exceed the 80% threshold. Other states have a “reverse offset,” in which your workers’ comp payments are reduced.
Other Fees to Consider
There are some other fees and miscellaneous details to keep in mind. For example, SSA subtracts legal fees, past and future medical costs, payments to dependents, and other expenses from the workers’ comp amount before calculating the offset. It is essential for you or your attorney to inform Social Security of these costs and provide the appropriate documentation.
Also, if you received a lump sum workers’ compensation settlement, Social Security will prorate the amount, after deducting expenses, to calculate your monthly rate.
Reducing Taxable Income From a Workers’ Comp Settlement
It’s important that your workers’ compensation attorney structure your workers’ compensation settlement to minimize the offset. This will also minimize the tax burden.
The most common technique for minimizing your workers’ compensation tax burden is for the settlement agreement to state that the lump sum should be treated as if it were spread out over your expected lifetime. This is also known as an annuity by social security. By doing this, you still collect a lump sum, not small recurrent payments. However, the lump sum is counted to cover the rest of your life. Be sure that the monthly rate is identified in your settlement agreement.
Note: In some states, the settlement can only be spread through your retirement date, not the rest of your life. Either way, a concise and robust settlement agreement can eliminate your tax liability for workers’ comp benefits.
Are You Worried That Your Workers’ Compensation is Taxable?
For over 80 years, the experienced legal team at Krasno Krasno & Onwudinjo has won workers’ compensation benefits for injured workers throughout the Commonwealth of Pennsylvania. If you are worried that your workers’ compensation benefits may be taxed, consult us today. We have 12 offices statewide. Contact us online or call (844) 243-4814 for a free case evaluation.