If you are injured on the job, workers' compensation insurance carried by your employer should help pay your medical bills, prescriptions and physical therapy. In addition, it may pay indemnity for time you lose from work. State laws govern workers' compensation insurance and benefits, which in most cases are not subject to income tax.
The IRS exempts any benefits you receive under the requirements of a workers' compensation law. If an insurance company pays indemnity benefits according to a formula set down in a state law (for example, two-thirds of your pre-injury salary while you remain out of work), then those benefits are free of federal income tax, as is any settlement amount. If your employer agrees to pay you some extra money to help with living or medical expenses -- over and above what the law requires -- then that income would be taxable. As a general rule, state income tax rules follow the federal guideline.
Light Duty Payments
In some cases, workers who return to the job while restricted to "light duty" continue to earn indemnity benefits. If you return to work, any workers' compensation payments you continue to receive are taxable. You must report them as wages on your federal tax return, which in most states carries over as taxable income on your state tax return. You report the payments whether or not they are included on your Form W-2.
Social Security Offsets
If you apply for Social Security disability benefits and are approved, you may be subject to an workers' compensation offset. According to the Social Security rules, the combination of disability and workers' compensation benefits cannot exceed 80 percent of your pre-injury wages. If it does, Social Security will offset your monthly disability benefits, reducing them until the 80 percent threshold is reached. The IRS still considers the offset amount -- which is paid instead by the workers' compensation carrier -- to be a Social Security payment, which may be subject to income tax according to your income level and filing status.
Workers' compensation medical benefits, such as payment of hospital bills, prescriptions, doctor visits and physical therapy, are not included in your income. However, these payments are subtracted from the amount you calculate for the itemized medical expense deduction. The IRS limits the amount of the deduction to that portion of expenses that exceeds 7.5 percent of your adjusted gross income.
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