If you currently receive workers compensation benefits, or you plan to apply for workers comp benefits after a work-related accident, injury or illness, you may ask, “Is workers compensation taxable?”
The answer, according to IRS, is that a small part of workers comp benefits may indeed be taxable but very few injured employees actually pay taxes on it. That’s why most people consider workers compensation monetary benefits as tax-free income for federal and state tax purposes.
Workers Compensation Benefits and Taxes
Workers comp benefits aren’t usually considered as taxable income on a federal or state income tax return. A single exception arises when the taxpayer also receives Social Security disability benefits (SSDI) or Supplemental Security Income (SSI).
In some instances, Social Security Administration (SSA) may lower the amount of SSDI/SSI received by the disabled individual to bring disability payments below the required threshold. SSA calls this calculation the <i>workers compensation offset.</i>
Workers compensation benefits are taxable in the same amount SSA reduces the injured beneficiary’s disability payments. Therefore, if SSA reduces the monthly SSDI payment by USD 250 because of workers comp offset, then USD 250 of the workers comp benefit is considered taxable.
Many beneficiaries receiving Social Security and/or workers compensation benefits don’t earn a lot of money and many don’t earn enough to owe IRS federal taxes. Even if a small portion of workers comp benefits are considered taxable, the injured disabled worker probably won’t owe money to the federal government.
Workers Compensation, SSDI, and Federal Taxes
If the injured worker or his or her spouse has a source of income other than workers comp or SSDI benefits, it’s possible to necessitate federal tax payments on SSDI. Here’s an example:
- You file taxes as an individual. Your annual income is greater than USD 25,000 but less than USD 34,000 per year.
- In this scenario, you’d be required to pay tax on approximately half of these benefits.
- If you’re married and file jointly with a spouse, you’re allowed to have combined income of USD 32,00 before you’ll be required to pay federal taxes on 50 percent of your benefits.
- If you’re single and you receive greater than USD 34,000, 85 percent of benefits may be taxable.
- If you’re married and receive more than USD 44,000, up to 85 percent of benefits may be taxed.
Disability benefits may be subject to taxes when the disabled person’s income is higher than the referenced limits. Disability benefits are then taxed at the taxpayer’s marginal tax rate. This means instead of paying taxes of half to 85 percent of benefits income, you’d probably pay tax of approximately 10 to 15 percent on half to 85 percent of benefits income. Someone earning a higher income might pay tax of 33 to 35 percent on up to 85 percent of benefits.
Most U.S. states don’t tax the disabled individual’s benefits but several tax them in similar fashion to the U.S. government. For instance, Montana, New Mexico and Utah fully tax Social Security benefits whereas Minnesota, West Virginia, Nebraska, Vermont, North Dakota, and Rhode Island tax Social Security benefits at the federal rate.
Individual taxpayers may apply related credits and/or deductions to benefits earned. Consult a CPA or financial adviser about disability and workers compensation benefits planning questions.
SSDI Lump-Sum Backpay and Taxes
SSDI beneficiaries typically receive a lump-sum “backpay” amount for “past-due” payments SSA owes the beneficiary. Because the lump-sum back payment is paid in one tax year, the recipient’s tax rate may rise due to the lump sum payment.
It may be possible to apply backpay income to a prior year in which your tax rate was lower. Consult a CPA or tax attorney to discuss SSDI taxation and back-payment if this applies to you.
Workers Compensation Offset Application
Disabled or injured workers who receive workers compensation and SSDA benefits can’t earn an amount that’s higher than 80 percent of average earnings from a job. In this case, <i>average current earnings</i> is the largest of the following items:
- 1/60th of total wages in the highest-earning five year period (in a row)
- 1/12th of total wages from the highest-earning year (of preceding five years)
- Average monthly income used to calculate benefits
In some states, Social Security payments are reduced until the beneficiary no longer exceeds the defined 80 percent threshold. Other states use a reverse offset method—in that scenario, the beneficiary’s workers compensation benefits payments are decreased.