California State law requires employers to purchase workers’ compensation insurance in case an employee suffers from a work-related illness or sustains injuries at work. The benefits fill the financial gap when an employee is unable to work but needs to pay medical bills. Workers’ compensation covers costs related to medical care, lost income and retraining where the employee has to seek a new line of work or position. However, the benefits do not cover pain and suffering.
All income is subject to federal or state taxation. If you suffer a work-related injury and are receiving compensation benefits, you probably are looking to minimize taxation to save money for your medical bills. The question is, are workers’ compensation benefits taxable? The answer in most cases is no. At The Workers Compensation Attorney Group, we can help you understand the tax implications associated with your workers' compensation benefits. We are competent and experienced in guiding our clients in Long Beach, CA, through strict workers' compensation laws and procedures.
California Laws on Workers’ Compensation
Workers’ compensation insurance is a program mandated by the state. It consists of payments that an employee must receive if they suffer work-related disabilities, injuries or sickness. It is a no-fault system where you receive compensation for your work-related illness or injury regardless of who was at fault. In return, you may be prohibited from filing a lawsuit against your employer.
The statutes governing workers’ compensation are detailed in California’s Labor Code. This code also describes the different types of benefits available to employees under the workers’ compensation insurance coverage.
Section 3700: Employers must purchase workers’ compensation insurance for all their employees, with limited exceptions as defined in Section 3351 and subsequent sections.
Section 4600: You are entitled to medical care including doctors’ visits, lab tests, x-rays, hospital services, medical equipment, medicine and any other medical services you may need during your recovery.
Section 4650, and the subsequent sections: You are entitled to temporary disability payments. These are payments that you will receive for lost wages while you are recovering. The payments are calculated as two-thirds of your pre-tax income but do not exceed 104 weeks.
Section 4658: If you do not recover from the injury completely, and as a result, you suffer measurable, permanent mental or physical impairment, you are eligible to receive permanent disability payments. The duration and amount of benefits will depend on the magnitude of your disability.
Section 4658.7: You will receive payment for retraining if, after recovery, you are unable to resume your previous employment. You can either retrain for a different position with the same employer or a different job in a different sector.
Section 4700: Your dependents will receive compensation if your work-related illness or injuries are fatal.
An Overview of California’s Taxable Personal Income
California levies personal income tax in addition to federal government taxes. However, the laws on personal income tax are progressive. If you are a high earner, you pay higher tax rates than those whose incomes are relatively small.
Under California’s Revenue and Taxation Code Section 17041, and the following codes, you must pay a proportional income tax share if you are a resident person including trusts and estates, a non-resident or a part-year resident. You are required to pay income tax on both earned income and unearned income.
Earned income includes:
Some non-cash fringe benefits
Social security benefits if you exceed a specific amount
Foreign earned income excluded from your federal tax returns
Unearned income includes:
Interest on compensatory benefits
Interest earned on local, municipal or state bonds outside California
Income from businesses and farms
Profits from the sale of assets
Winnings from gambling
Winnings in lawsuits
Are Workers Compensation Benefits Subject to Taxation?
The answer is no. As detailed in Publication 907, workers’ compensation for occupational injuries or sickness is tax exempt if it is paid under a workers’ compensation act or other similar law. Therefore, benefits awarded to you under any workers’ compensation statute are fully exempted from tax at both federal and state levels.
Workers compensation is federally funded as a public benefit for the purpose of helping employees pay their bills while recovering from a work-related injury or illness. It is not subject to taxation because the program is tax-funded and taxing the benefits would be channeling money back into the same system. In addition, payments made to your survivors due to a work-related fatality are also exempt.
Workers’ compensation benefits are categorized as non-taxable income similar to:
Payments you receive from public welfare
Compensatory damages for sickness or physical injury excluding punitive damages
Disability benefits from a "no-fault" auto insurance policy as compensation for injuries resulting in loss of income or loss of your earning capacity.
Compensation for permanent disfigurement, permanent loss of a part of your body, or permanent loss of use of a part or a function of your body.
Refunds on state income tax
Compensation for unemployment
Lottery winnings within California state
Paid maternity or family leave because it is taxed at the federal level
Distributions from health savings accounts (HSA)
Railroad and Social Security retirement benefits, excluding federal, state, local and private pensions
Interest earned from federal bonds
Exceptions to Tax-Exempt Status
Although workers’ compensation benefits are considered non-taxable income, there is an exception. Most workers receiving workers’ compensation benefits do not apply for social security. However, if their condition deteriorates, they may receive permanent disability benefits. Part of those benefits may be taxable if you receive Supplemental Security Income (SSI) or Social Security Disability Income in addition to your workers’ compensation.
If your Social Security benefits are reduced by your workers’ compensation benefits, the amount of reduction is taxable. If the combined income you receive from Supplemental Security Income (SSI) or Social Security Disability Insurance (SSDI) and workers’ compensation exceeds 80% of your current pre-injury earnings or disability income, the SSDI benefits will reduce (offset) any income above the 80% limit.
For example, if your monthly workers’ compensation benefits are $2,000 and $2,200 in SSDI benefits, the monthly total would be $4,200. If your monthly earnings before you suffered injuries were $4,500, the combined benefits would be 93.3% of your pre-injury income, which exceeds the permitted 80% limit. The equivalent of 80% of your pre-injury income ($4,500) is $3,600. In order to lower your combined benefits to 80% of your previous income, your SSDI benefits must be lowered (offset) by $600 ($4,200 - $3,600). Therefore, $600 of your workers’ compensation benefits is taxable. The amount taxed is equal to the amount reduced on SSDI benefits. However, this offset does not affect Social Security retirement benefits.
If your SSDI benefits are offset, your workers' compensation benefits will be taxed because Social Security benefits become taxable once your income reaches a specific amount. The offset is taxed if your income for that year is high enough. This also applies even when the offset is from workers’ compensation and not from SSDI or SSI. The taxable amount is often negligible. In most cases, if you qualify for Social Security Disability Insurance and Supplemental Security Income, your taxable income is not high enough to owe any taxes at the federal or state level.
Before calculating the offset, Social Security will deduct some costs from your anticipated workers’ compensation income. These include legal fees, past and expected medical expenses, payments to your dependents and other relevant expenses. You, therefore, need to inform your workers’ compensation lawyer of these costs so they can prepare the necessary documentation and inform Social Security.
Although workers’ compensation benefits are tax exempt, under Section 132a of the California Labor Code, the benefits may be taxed if they were awarded in a lawsuit arising from an act considered as discrimination.
How Your Average Current Earnings are Calculated
For purposes of determining the offset, Social Security Administration will use either of the following three formulas to determine your average current earnings.
The High-One Formula: It involves using one-twelfth (1/12) of your total earnings from the year you earned highest in the preceding five years.
The High-Five Formula: This method uses one-sixtieth (1/60) of your total salary in the five consecutive years that you earned the highest.
The Average Monthly Wage Formula: This formula uses your average earnings per month based on your first application for benefits.
Social Security Administration uses the formula that is most beneficial for your condition. However, they favor the High-One Formula in the majority of cases.
Workers’ Compensation Benefits and Social Security
If you specifically receive both workers’ compensation benefits and Social Security disability, your social security benefits will be taxed up to a specific level. In some instances, your Social Security benefits may be taxed in full if your income exceeds specific base amounts. These base amounts are:
$25,000 if you are filing as a head of household, single or a qualifying widow or widower who has a dependent child. It also applies if you are married, filing your taxes separately and never lived with your spouse in the year.
$32,000 if you are filing jointly as married taxpayers
$0 if you are married, lived together at any time in the year but, filing your taxes separately. However, the tax may be charged on a portion of your benefits.
Maximizing Your Benefits and Minimizing Taxation
If you receive Social Security disability benefits simultaneously with workers’ compensation benefits, your attorney can design a settlement plan that minimizes your workers’ compensation offset and the taxes you may be required to pay. Your workers’ compensation agreement should specifically have the lump sum regarded as partial payments spread over the rest of your expected lifetime. You will then receive a lump sum payment instead of small monthly payments, with calculations based on actuarial figures. The lump sum is meant to cover the remainder of your expected lifespan. It is critical to ensure that your monthly rate is indicated in your workers’ compensation agreement.
For Social Security to regard your lump sum as small monthly payments, the agreement on your workers’ compensation settlement must include an amortization provision. The amortization provision must be part of the original agreement. If you try to add it later, it will seem like you are attempting to circumvent the offset and it will alert Social Security. It is possible in some cases to use annuities in the settlement. If you choose to do so, Social Security will use the annuity to calculate your workers’ compensation offset.
For example, if you receive a workers’ compensation settlement of $20,000, and your expected lifespan is 540 more months (45 years), the payment will be spread across the 540 months. Social Security calculates your offset if your monthly income exceeds 80% of your pre-injury income. Since your monthly workers’ compensation as calculated by Social Security will be $37.04, you will have more SSDI benefits and lower your tax liability. However, instead of small monthly payments for the entire 540 months, you will receive the total amount in a single payment.
Sometimes, your workers’ compensation can only cover up to your date of retirement and not your entire life. Whichever the case, a well-designed settlement agreement can reduce or eliminate your tax liability on your workers’ compensation benefits. Receiving a lump sum amount from past workers' compensation is different from a lump sum settlement. If your compensation was delayed due to a lawsuit and the settlement was approved by the court, you can enlist the help of a tax attorney or accountant to develop a payment schedule to minimize taxation. You can do the same if you decide to retire while you are still receiving workers’ compensation payments.
For a settlement agreement, you take a lump sum cash settlement thereby releasing your insurance provider or employer from future payment of monthly benefits and from any liability for future medical costs. If you are unable to agree on a settlement with your insurer or employer and your case goes to trial, you will not be able to schedule your workers’ compensation payments to your advantage. You will also not receive lifetime amortization from the court. Therefore, your offset will not be minimized. You will have to live with the rate indicated in your settlement for permanent disability.
Find Out Whether You Owe Taxes on Your Workers’ Compensation
Your employer is required by the federal Internal Revenue Service (IRS) to report your salary and wage information on a W-2 form. The W-2 form also reflects the amount of state, federal and other income taxes that your employer withheld from your paycheck in the preceding calendar year.
The amount for which you owe taxes will be reflected in your W-2. Since your periodical or lump sum workers’ compensation payments are not subject to state or federal taxes, they will not be included in this amount. However, other benefits that are considered income will reflect on the amount.
Other Tax Issues Related to Workers’ Compensation Benefits
Most people who receive workers’ compensation benefits resume work eventually. Some are able to earn wages by performing lighter duties while at the same time receiving workers’ compensation benefits. Wages earned from light duties in addition to workers’ compensation benefits are taxable.
For example, suppose you are a roofer, and your employer offers you lighter office duties after you sustain a fracture from a fall while on duty. If your wages in the new position are at the same rate as your pre-injury wages, the wages are subject to income tax. However, you are entitled to receive a tax exemption on your temporary disability benefits if your wages are less than before. Still, your light-duty wages are taxable.
Social Security Retirement Benefits
Although workers’ compensation benefits are non-taxable, the retirement benefits you receive based on previous contributions, age or years of service are taxable. Even if you retired due to a work-related injury or illness that resulted in workers’ compensation benefits, your retirement benefits will be taxed. Unlike the Social Security Disability Insurance, workers’ compensation offset is not applied to your retirement benefits. Early retirement may offer you lower monthly Social Security payments. However, you need to consult with your attorney to help you determine whether early retirement is a wise decision.
Interest on payments
If your insurance provider caused a significant delay or was engaged in egregious conduct, you may receive interest on your workers’ compensation benefits. That interest is taxable.
Workers’ compensation benefits that your family or dependents may receive after in case you die from a work-related sickness or injuries do not constitute taxable income.
Frequently Asked Questions About Workers’ Compensation Benefits and Taxation
Do my workers’ compensation benefits have an effect on my tax return?
You will not have to pay taxes on workers’ compensation benefits if you received the benefits through the full tax year. However, if during the year you resumed work regardless of the length of time or workload, the wages are taxable. In addition, if you took money from a retirement plan or a 401k to subsidize your income while you were receiving workers’ compensation benefits, you will pay tax on that income.
If you are married, you received workers’ compensation throughout the tax year while your spouse worked the entire year, and you did not receive any taxable income to subsidize your benefits, you have no tax obligations for that year. If you file your tax returns jointly with your spouse, your lack of taxable income may lower your total amount of tax payable by putting you in a lower tax grouping. You will report the less total taxable income. Therefore, you will have a lower tax return than when both of you worked for the whole tax year.
Do I claim workers’ compensation on taxes?
No. You do not have to claim workers’ compensation benefits since they are not subject to tax. However, your retirement benefits will be taxed if you retire as a result of an occupational injury or sickness, or if your workers’ compensation income reduces your railroad or Social Security retirement benefits.
Can I collect workers’ compensation and Social Security benefits simultaneously?
You can only receive both categories of benefits if you qualify for Social Security benefits. However, Social Security payments may be offset (reduced) so that your income does not exceed 80 percent of your earnings before injuries.
Why did I not receive my W-2?
If you received workers’ compensation throughout the entire tax year, you will not have tax notification documents sent to you. However, if you also received Social Security Disability in addition to workers’ compensation, you will receive a tax notification for your Social Security Disability Income.
Will I pay tax on my lump sum workers’ compensation settlement?
No. Whether you received workers’ compensation as a lump sum or periodical wage loss benefits, those payments are not taxable. As long as the benefits were paid under a workers’ compensation statute, you will not owe any tax on them.
Can the IRS use my workers’ compensation settlement to offset my tax liability?
Although IRS is permitted to use different types of assets to recover tax debt, they cannot use your workers’ compensation benefits to settle any tax debts you owe. You will receive the full amount of your compensation.
Find a Workers’ Compensation Attorney Near Me
Receiving workers’ compensation benefits after a work-related injury can be a real life saver especially when you have medical bills to pay, and little or no income to cover your basic needs. Losing your a part of compensation through taxes can be a nightmare. The Workers Compensation Attorney Group is a group of seasoned attorneys who understand workers’ compensation laws and will help you navigate the complex taxation system. We will advise and help you learn about the tax obligations on your workers’ compensation benefits. If you work in or around Long Beach, CA, call workers compensation attorney at 714-716-5933, and we will design a settlement to help you minimize or eliminate your workers’ compensation offset.