The short answer is no. Workers’ comp isn’t taxable income. You get it as a result of injury and lost wages. However, if these benefits are combined with social security disability insurance (SSDI) or any other retirement payment, a portion of your income becomes subject to taxes.
Federal and State Taxability of Worker Comp
Worker compensation money isn’t taxable at the federal level. However, states have their own rules. Some follow federal tax rules as it is and some with variations. Below, we have explained both federal and state taxability of WC and how you can get a lower minimum.
The Federal Rule (Federal):
According to IRS rules, workers’ compensation for occupational sickness or injury is fully tax-exempt. Whether you receive workers’ comp payments weekly or in a lump sum workers’ comp settlement, it remains tax-free.
New York Specific Rules:
New York State follows federal rules. That means you don’t have to pay any taxes on WC. However, some exceptions exist.
Understanding Workers' Comp Settlements & Taxability
When it comes to workers’ compensation settlements, it remains tax-free. But it shouldn’t exceed 80% of your regular income.
Is a Lump Sum Workers' Comp Settlement Taxable?
A lump sum workers’ comp settlement is treated the same as weekly payments. The portion covering the injury and lost wages is typically not taxable. This includes:
- Money paid for medical costs
- Payments for permanent disability
- Reimbursement of temporarily lost wages.
The Non-Taxable Nature of Workers' Comp Benefits
The IRS considers workers’ comp a replacement for the loss of physical capital (your body). It’s compensation for injury-related economic losses, not earned taxable income.
Additionally, you will not receive a Form W-2 or 1099 for your workers’ compensation benefits. Confirming their non-taxable status.
The Critical IRS Exceptions That Make Workers' Comp Taxable
If you are receiving SSDI or SSI, your tax scenario can be different. Further, any delay resulting in interest on the capital amount is considered taxable.
The Social Security Disability Insurance (SSDI) Offset
This is the most common way a portion of your benefit becomes taxable. As discussed earlier, your total combined benefit for workers’ comp and SSDI should not exceed 80% of your pre-injury average current earnings. If you receive SSDI, here is what happens:
- The Social Security Administration (SSA) will offset (reduce) your SSDI payment.
- The amount your SSDI is reduced by the offset is then considered a replacement of a taxable benefit (SSDI) and may become taxable.
Taxation of Retirement, Interest, and Severance Pay
If you get retirement benefits or severance pay, you will have to pay taxes on their specific portion. Here are the details.
Retirement Benefits:
If your workers’ comp payments reduce or replace benefits from an employer-funded retirement plan (even if you retired due to injury), the retirement portion may be taxable income.
Interest on Delayed Payments:
Any interest earned on a delayed settlement payment is typically considered taxable interest income and must be reported.
Back Wages/Severance:
Payments designated specifically as taxable back wages or severance (rather than injury compensation) may be taxed.
Final Verdict:
Workers’ comp is tax-free until and unless combined with other benefits. If you have multiple benefits and are confused about which to report or exclude. You can benefit from the tax preparation services of Tax King. We have experienced professionals for both personal and business tax preparations. Count on us for lump sum structuring and reporting requirements.
