Any change in your income can impact your income tax return since the IRS taxes different types of income at different rates. The most important thing to determine when assessing your tax situation is whether your income is taxable or nontaxable. After you've made that initial determination, it's easier to attribute a tax rate to your income and file a return. Generally, workers' compensation is not taxable, but there are some specific circumstances when receiving workers' compensation for an entire year will not absolve you from paying tax.
Any workers compensation you receive as part of a work-related injury or sickness is normally fully exempt from taxation. This exempt status applies to any money you receive as well as any survivors benefits bequeathed to a family member. The tax exemption does not apply to retirement plan benefits you receive or unemployment compensation.
Although workers' compensation is not taxable, you are still required to file a return if the income you earned in addition to your workers' compensation meets the IRS filing requirements. For example, if you took money out of a 401(k) to subsidize your income while you were receiving workers' compensation, that distribution may be subject to lump-sum distribution tax treatment on your return. In addition, if your workers' compensation reduces your Social Security benefit, that portion of your workers’ compensation may be taxable.
Since workers' compensation is not subject to tax, you are not required to include it on your income tax return. Other forms of disability compensation that are not required to be included on your return are court awards you received for a disability or injury, benefits you receive under an accident or health insurance policy on which either you or your employer paid premiums, disability benefits you receive to compensate you for a loss of income from a no-fault of insurance policy, and compensation you receive for permanent loss of use of a part of your body.
Before filing, check to be sure that you were on workers' compensation for the entire year, because if you return to work, wages earned during that period, even those earned while on light duty, are taxable.
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