Workers' compensation benefits are not normally considered taxable income at the state or federal level. The lone exception arises when an individual also receives disability benefits through Social Security disability insurance (SSDI) or Supplemental Security Income (SSI).
In some cases, the Social Security Administration (SSA) may reduce a person's SSDI or SSI so that the combined amount of the workers' comp benefits and the disability payments remains below a certain threshold. This is called the workers' compensation offset.
The amount of workers' comp that is taxable is the same amount by which Social Security reduces your disability payments. Thus, if SSA lowers your monthly SSDI check by $250 due to the workers' compensation offset, then $250 of your workers' comp is taxable.
Most people who receive Social Security and workers' comp benefits don't have enough taxable income to owe federal taxes, so even if a portion of your benefits are taxable, it's not likely you'll owe taxes. (Read Are Social Security Disability Benefits Taxable? to find out the income limits.)
Moreover, an experienced workers' compensation attorney may be able to structure your workers' comp settlement in a way that minimizes the offset and reduces your taxable income. Thus, while a portion of your workers' comp may considered taxable income, in practice the taxes paid on workers' comp are usually small or non-existent.
If you're receiving both workers' compensation and Social Security disability benefits, the combined amount of your benefits cannot exceed 80% of your average current earnings. Your "average current earnings" are defined as the largest of:
In most states, your Social Security payments are lowered until you no longer exceed the 80% threshold. A minority of states have a "reverse offset," in which your workers' comp payments are reduced.
Social Security will subtract legal fees, past and future medical costs, payments to dependents, and other expenses from the workers' comp amount prior to calculating the offset. It is essential for you or your attorney to inform Social Security of these expenses and provide the appropriate documentation.
Example: John's average current earnings are $2,500. He is eligible for a monthly SSDI benefit of $1,500 and monthly workers' comp of $800, for a total of $2,300 per month. Because that amount exceeds $2,000 (80% of his average current earnings), in most states John's SSDI will be reduced by $300. So John will receive $1,200 from SSDI and $800 from workers' comp, for a total of $2,000.
John would be taxed on the $1,200 SSDI amount and $300 of the workers' comp benefit, because the SSDI was reduced by $300. John is treated for tax purposes as having received the full $1,500 in SSDI benefits, even though $300 of that amount was paid by workers' comp.
If you've received a lump sum from workers' comp, Social Security will prorate the settlement amount, after deducting expenses, to come up with your monthly rate.
It's important that your attorney structure your workers' compensation settlement in a way that minimizes the workers' comp offset. This will also minimize the taxes you might have to pay.
The most common technique is for the workers' comp settlement agreement to state that the lump sum should be treated as being spread out through your expected lifetime. In this situation, you still collect a lump sum, not small periodic payments, but the lump sum is considered to cover the remainder of your lifespan according to actuarial tables. Be sure that the monthly rate is identified in your settlement agreement.
Example: Consider a person with an expected lifespan of 450 more months who receives a $13,500 workers' compensation settlement. If the settlement agreement provides that the lump sum is spread out over the beneficiary's lifetime, Social Security will usually find that the prorated monthly amount is $30 ($13,500 divided by 450 months).
Note that in a few areas, the settlement can only be spread through your retirement date, not for the rest of your actuarial life. Either way, a well-drafted settlement agreement can often eliminate your tax liability for workers' comp benefits.
Although workers' comp benefits generally are not taxable, any retirement benefits you've collected based on your age, years of service, or prior contributions, are not exempt from taxation. This is true even if you've retired due to an illness or injury that gave rise to a workers' comp claim.
Most people who receive workers' comp do return to work eventually. Some of those perform "light work" while continuing to receive a portion of their workers' comp benefits. Any wages earned while you're still receiving workers' comp benefits are considered taxable income.
Occasionally workers' compensation benefits are paid with interest, often when the insurance company caused a considerable delay or was involved in egregious conduct. Any interest paid is considered taxable income.
Workers' compensation benefits paid to surviving family members after a worker's death are not considered taxable income.
If you have the potential of receiving both Social Security and workers' compensation benefits, it's important to contact an experienced disability attorney as soon as possible. These kinds of cases can be highly complex, and trying to navigate the system alone could be very expensive in the long run.