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Are Workers' Compensation Benefits Considered Taxable Income by the IRS?

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As tax time approaches, we have received several calls from clients asking about the tax consequences for those receiving weekly benefits, as well as those who have received a lump sum settlement.  Specifically, injured workers want to know: “are my workers compensation benefits treated as taxable income?”  The short answer to this question is no; workers compensation payments are income tax free.  If you have questions regarding tax questions because of your individual circumstances, however, you should consult a tax professional immediately.

Regarding the general proposition that workers compensation benefits are not taxable as income, IRS Publication 525 provides the following:

“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. The exemption also applies to your survivors. The exemption, however, does not apply to retirement plan benefits you receive based on your age, length of service, or prior contributions to the plan, even if you retired because of an occupational sickness or injury. “

A caveat however, is that if part of your workers’ compensation reduces your social security or equivalent railroad retirement benefits received, that part is considered social security (or equivalent railroad retirement) benefits and may be taxable.

Additionally, if you return to work after qualifying for workers’ compensation, salary payments you receive for performing light duties are taxable as wages.  Therefore, you should be prepared for this when filing your return after returning to work in a light duty capacity.

If your disability pension is paid under a statute that provides benefits only to employees with service-connected disabilities, part of it may be workers’ compensation. That part is exempt from tax. The rest of your pension, based on years of service, is taxable as pension or annuity income. If you die, the part of your survivors’ benefit that is a continuation of the workers’ compensation is exempt from tax.

Even though there may not be tax consequences to your receipt of workers compensation benefits, there can be a significant effect on government assistance you are receiving.  Many people with lower incomes receive Supplemental Security Income, Medicaid, cash assistance, food stamps, or other governmental aid.  If you settle your workers compensation claim for a lump sum your eligibility for these types of assistance may be jeopardized.  Therefore, if you have a current workers compensation claim, and are receiving public assistance, it is imperative that you discuss the repercussions settling can have on your entitlements..

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