How Does Workers’ Comp Affect Tax Returns?

Workers’ compensation pays your medical bills and replaces a portion of your lost wages when you get injured on the job. Most workers’ comp payments are tax-free, but there are exceptions. A Pennsylvania workers’ comp lawyer can explain your benefits and any potential tax implications.

You don’t want to guess your way through this, only to face IRS penalties for not completing the required steps. If you’re thinking about settling your claim or are already receiving workers’ compensation payments, an attorney can explain your options and help you prevent tax issues before they happen.

How Does Workers’ Comp Affect Your Tax Return?

Workers’ compensation benefits usually do not affect your tax return. At the federal level, the IRS says you don’t have to report workers’ comp benefits as income. These include benefits for wage loss, medical expenses, specific loss payments, and death benefits. They do not count as taxable income because they represent a form of compensation for a loss rather than a type of profit. Therefore, you do not need to report them as income on your tax return.

Pennsylvania follows the same rule. The state does not treat workers’ comp benefits as income. You don’t pay Pennsylvania income tax on these payments, and you don’t include them in your PA-40 return. If your only income is workers’ compensation income, you likely don’t need to file a return at all unless you meet other filing requirements.

Is a Lump Sum Workers’ Comp Settlement Taxable?

As for whether a lump sum workers’ comp settlement is taxable, the government usually does not tax it. The IRS treats this money the same way as regular weekly or biweekly workers’ comp checks, as long as the payment comes from a workers’ compensation program and relates to a work-related injury or illness. You do not report it as income on your federal return.

The Pennsylvania Department of Revenue also excludes lump sum settlements from taxable income. These payments fall under the same rule that protects workers’ comp from state income tax. You usually don’t need to include a lump sum settlement on your PA return.

If part of the settlement replaces Social Security Disability benefits or includes back pay from a different source, that part might get taxed. However, most people who receive workers’ comp settlements don’t owe any state or federal tax on that money.

When Workers’ Comp May Become Taxable

It’s important to know that workers’ comp payments can become taxable in two primary ways.

First, if you also receive Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI), then Social Security could reduce your SSDI or SSI due to your workers’ comp. If this happens, the IRS might tax part of your workers’ comp because it counts that portion as Social Security income.

Second, if you agree to let your employer pay you your regular salary while you’re out and send your workers’ comp benefits directly to them, that salary becomes taxable. This setup, known as a salary continuation plan, treats your wages as taxable, just like any other paycheck.

In both situations, Pennsylvania and federal tax rules are the same. Regular workers’ comp stays tax-free, but wages or offset benefits can be taxed.

How to Handle Workers’ Comp on Your Tax Return

If you have been receiving workers’ compensation benefits, you usually don’t need to report them on your tax return. The IRS does not consider your benefits taxable if they come from a state or federal workers’ comp program. You should not list these payments as income when you file your federal return.

Pennsylvania follows the same rule. The Department of Revenue does not require you to include workers’ comp benefits on your PA-40 form. These payments do not count toward your taxable income.

You only need to take extra steps if your workers’ comp affects other benefits. If your payments reduce your Social Security benefits, you might need to report a portion of them as taxable. Also, if you receive a salary continuation or return to work on light duty and get paid, you must report those wages.

When in doubt, it’s best to double-check with a professional before submitting your tax return.

Common Tax Mistakes Injured Workers Make

Many people assume workers’ comp payments automatically come with no tax problems, but that’s not always the case. The following are some common mistakes to avoid:

• Reporting Tax-Free Benefits as Income – You do not need to list workers’ comp on your federal or state return unless part of it replaces another taxable benefit.
• Skipping Tax on Light-Duty Wages – If you go back to work and get paid for lighter tasks, you must report those wages, even if they’re less than what you normally earn.
• Forgetting SSDI or SSI Offsets – If workers’ comp reduces your Social Security Disability payments, a portion of the offset could be taxable.
• Not Keeping Records – You should always save settlement paperwork, Social Security letters, and pay stubs in case questions arise during tax season.

Do You Need a Workers’ Comp Lawyer or Tax Professional?

In most cases, you don’t need a tax expert to handle workers’ comp-related taxes because there usually aren’t any. However, if your claim includes Social Security offsets or salary continuation, the situation could get more complicated. A tax pro can help you determine which parts of your benefits might be taxable and how to report them correctly.

A workers’ compensation lawyer can explain your benefits and protect your rights from the time you file your workers’ comp claim until the time you file your taxes. If you haven’t settled your claim yet, an attorney can review the terms to prevent surprises during tax season. 

If your claim is large or involves mixed payments, your lawyer might work with a tax professional to determine whether you do have to pay taxes on any portion of your workers’ comp payments. However, your first step should be to talk with an attorney who is familiar with Pennsylvania’s workers’ compensation laws.

Contact Our Hershey, PA, Workers’ Comp Attorneys to Learn More

If you have questions about your workers’ compensation claim or how it might affect your taxes, reach out to Calhoon & Kaminsky P.C. We help injured workers across Pennsylvania access the benefits they need and address any tax considerations that follow. Contact us today to get started with your free, no-obligation consultation session and learn more about how we may be able to help you.