In most cases, no.
Workers' compensation benefits are generally exempt from federal income tax, and that usually includes a workers' compensation settlement. In fact, IRS Publication 525 describes these benefits as fully exempt from federal income tax.
The good news is that most injured individuals don't have to worry about federal taxes on their settlement funds. However, there are a few important exceptions to understand, especially if you're also receiving Social Security disability benefits.
What the tax exemption covers
Federal tax law excludes money received through a workers' compensation program as compensation for a work-related injury or illness.
That exemption generally applies whether you receive benefits through weekly payments during your claim or a lump-sum settlement when your case resolves. It can also apply to benefits paid to eligible survivors.
The tax exemption also includes funds allocated for future medical care. That means Medicare Set Aside (MSA) funds aren't taxed when you receive them.
Because those funds are already tax-free, the IRS generally doesn't allow you to claim a deduction for medical expenses paid with that money. You can learn more in IRS Publication 502.
Which amounts can be taxable?
While workers' compensation benefits themselves are typically tax-free, some income connected to a work injury may still be taxable.
- Social Security disability offset. If your workers' compensation benefits reduce your Social Security Disability Insurance (SSDI) payments, the IRS may treat the reduced amount as a Social Security benefit. Depending on your overall income, that amount could be taxable. You'll typically see the adjustment listed on your Form SSA-1099 as a workers' compensation offset.
- Light-duty wages. If you return to work in a light-duty position, those wages are generally taxed just like any other paycheck.
- Retirement plan benefits. Retirement income based on age, years of service, or plan contributions is often taxable, even if you retired because of your injury.
- Whether an SSDI offset applies depends on your disability benefits and your pre-injury earnings.
Our FAQ on how a settlement affects SSDI, SSI, and Medicaid explains how those rules work in more detail.
Why interest on your settlement may be taxable
While your settlement itself is generally tax-free, the interest it earns after you've received the money usually is not.
For example, if settlement funds are held in a savings account, the interest earned is typically taxable income. Your financial institution may report that interest on Form 1099-INT, but you're responsible for reporting taxable interest whether you receive a form or not.
The same concept applies to an MSA account. Interest earned within the account may be taxable, even though the original settlement funds are not.
The good news? Medicare's guidelines allow taxes on MSA interest earnings to be paid from the MSA account itself.
For individuals using CareGuard, Ametros provides a 1099-INT for their account whenever the account earns more than $10 in interest during the year.
When should you talk to a tax professional?
Every situation is different.
This FAQ covers general federal tax rules and shouldn't be considered tax advice. Factors such as your settlement language, other sources of income, retirement benefits, Social Security benefits, and state tax laws can all affect your individual situation.
If you have questions about how your settlement may affect your taxes, it's a good idea to consult a qualified tax professional before filing your return.
What this means for you
For most injured individuals, a workers' compensation settlement is not subject to federal income tax.
The exceptions usually involve other sources of income, such as SSDI benefits, wages earned after returning to work, retirement income, or interest earned after settlement funds are received.
Understanding those differences ahead of time can help you avoid surprises and make informed decisions about your settlement and future finances.
References
- Federal tax exclusion for workers' compensation (26 U.S.C. §104(a)(1))
- IRS Tax Topic 403: Interest received
Disclaimer:
The information provided here is for general educational and informational purposes only and is not intended nor does it constitute legal, tax or financial advice. We’re happy to explain general concepts and navigate resources; however, our guidance should not be relied upon as a substitute for advice from a qualified attorney, tax advisor, financial professional or other licensed advisor. Decisions regarding your specific circumstances should be made in consultation with the appropriate professional.
