California employers are obligated to have workers’ compensation insurance in the event that an employee(s) suffers work-related injury or illness. Such benefits can be a crucial lifeline after an employee isn’t able to work or collect a paycheck but is left with heavy medical bills. This helps them focus on recovery without having to face financial hardships. Workers compensation pays for costs associated with lost wages, medical care, and retraining in the event that an employee is forced to seek a new position or line of work. However, any pain and suffering that the injured employee might experience are not covered by workers’ compensation.
For many people who are currently relying on workers’ compensation benefits for their livelihood, it can be a real burden to lose any amount of money in the form of tax returns. But are workers’ compensation benefits taxable in California? For the most part, the answer is no. Worker’s compensation benefits in California are considered non-taxable income.
Workers’ compensation is a public, federally funded benefit designed to help employees settle their bills as they recover from a work-related illness or injury. Workers’ compensation is a tax-funded benefit and the main reason why it is exempt from taxes in the overwhelming majority of cases. Otherwise, paying taxes from this benefit would be feeding the money back into the system.
The tax-exempt nature of workers’ compensation insurance benefits puts them in the same category as other government benefits, such as compensatory damages for injury or illness, payments from public welfare, compensation for permanent disfigurement, and disability benefits under a no-fault car insurance policy. Death benefits paid to survivors in the event of a work-related fatality are also tax-exempt. You will not have to pay taxes for income received in this manner and there will also be no withholding. However, there’s one exception that applies since there are state and federal agencies that may tax workers’ compensation benefits.
If you’ve suffered a work-related injury or illness and are receiving workers’ compensation benefits in Orange County, CA, you can discuss the tax implications with a knowledgeable and experienced Orange County Workers Compensation Attorney. We would be happy to help you understand workers’ compensation law in California and how it pertains to you during a free consultation and case evaluation.
Understanding the Exemption to the Tax-Exempt Status
While workers’ compensation benefits are usually considered non-taxable income, there’s an exception to this and that can mean taxation. Put simply, part of your worker’s compensation benefits can be subjected to taxation if you also receive social security benefits, such as supplemental income or disability income, and part of those benefits have been offset by your workers’ comp insurance benefits. In California, if you’re receiving workers’ comp and Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI), and when put together the benefits surpass 80% of your average current earnings of pre-injury or disability income, the SSDI benefits will be offset (or reduced). In other words, the Social Security Disability benefits offset any form of income that exceeds this limit. It’s worth noting that Social Security retirement benefits are not affected by the offset.
Your benefits may be taxed when there is an offset because Social Security benefits are usually taxed when your total income reaches a certain point. So, if the offset with workers’ comp benefits causes a reduction in the amount of SSDI benefits, the offset could be subjected to taxes, provided your earning for that year are high enough. This applies even if the amount is received as workers’ comp benefits and not as SSI or SSDI. The taxable amount would be equal to the amount that your SSDI payments are reduced.
For example, say you would have been entitled to $1,000 in workers’ comp benefits and $1,200 in SSDI benefits, that would be a total of $2,200 a month. And if you earned $2,500 per month before you became disabled, the combined benefits of workers’ comp and SSDI benefits would be 88% of that amount, which is more than the 80% limit. In order to bring down the combined benefits to 80% of $2,000 or $2,500, your SSDI would have to be reduced by $200. This means that $200 of your workers’ compensation benefits could be subjected to taxation.
Also, under California Labor Code Section 132a, workers’ compensation benefits may incur a tax obligation if it resulted from an act of discrimination.
Calculating Your Average Current Earnings
The Social Security Administration uses one of three distinct formulae to calculate an individual’s average current earnings. These include:
- The Average Monthly Wage Formula: This involves the use of your average monthly income based on your initial benefits application
- The High-Five Formula: One-sixtieth (1/60) of the sum of your wages in your five highest-earning years in a row
- The High-One Formula: one-twelfth (1/12) of the sum of your wages from the highest-earning year in the last five years
The method used will be one that’s most favorable for your condition but the Social Security Administration tends to use the High-One Formula in most cases.
Many workers who receive workers’ compensation benefits don’t collect social security but if the condition of the worker deteriorates, they may also end up receiving permanent disability benefits. Returning to work or receiving other public benefits can impact the tax liability on your previously earned workers’ compensation.
Your benefits can also be subject to taxation if your tax situation exceeds certain base amounts. For instance, you can have a taxable income if you earn more than $25,000 as single tax filer. The number, on the other hand, is $0 for married individuals filing their taxes separately and $32,000 for married filers. It’s important to know this if you plan to file taxes separately while married.
In some instances, benefits can have a negligible effect on your finances if they have a low enough tax liability. If, for instance, you earned $3,500 per month before you became disabled, you can’t exceed 80% of that total with your workers’ comp and SSDI benefits. As such, if you collect above $2,900, which is 80% of $3,500, it means that your SSDI will be $2,900. The reduction is the taxable portion of your disability income. If the offset is $200, that’s what may be taxable.
Your Social Security benefits may be lowered until you are well at or below the 80% threshold. Prior to calculating the offset, Social Security will subtract payments to dependents, past and future medical costs, legal fees, and other expenses from your workers’ compensation income. For this reason, it’s important to let your workers’ compensation attorney know of these expenses so they can inform Social Security and provide the appropriate documentation.
Reducing Your Taxable Income and Maximizing Your Benefits
If you simultaneously receive workers’ compensation benefits and disability benefits from Social Security, it’s in your best interest to involve an attorney. Your workers’ compensation attorney can structure your settlement in a manner that minimizes workers’ compensation offset as well as any taxes you might have to pay. Basically, your workers’ comp settlement should specify that the lump sum should be treated as if it is spread out over your expected lifetime. So, instead of collecting small periodic payments, you receive a lump sum, but based on actuarial tables, the lump sum is considered to cover the remaining part of your expected lifespan. It’s important to ensure that the monthly rate is identified in your workers’ comp settlement agreement.
Say you receive $19,500 in workers’ compensation settlement and have an expected lifespan of 480 more months (40 years), and the lump sum is spread out over your lifetime. In this case, Social Security will calculate any SSDI offset is your combined income exceeds 80%. Social Security will find that the monthly amount is $40.62 per month ($19,500 divided by 480 months). But instead of receiving the settlement in small periodic checks over the course of the 480 months, you will collect it in one payment. And since you would have a lower monthly workers’ compensation income, you’d minimize any tax liability and would retain more SSDI payments.
It's important to understand that in some instances, your workers’ comp settlement can only be spread through your retirement date, instead of it being spread for the rest of your actuarial life. Regardless of how the benefits are spread, your tax liability for workers’ compensation benefits can be eliminated by a well-drafted settlement agreement.
To have Social Security consider a lump sum as monthly payments, an “amortization provision” must be included in your workers’ compensation settlement agreement. This amortization provision must be included in the original settlement since adding them later will raise flags with Social Security because it may look like you are trying to avoid the offset. In other cases, annuities can be used in the settlement, which means that the annuity will be used by the Social Security to compute the workers’ compensation offset.
A lump sum payment of past-due workers’ compensation is not the same as a lump sum settlement. In a settlement agreement, the claimant takes a cash settlement in the form of a lump sum and thus releases the employer or insurance provider from liability for future medical expenses and future monthly benefit payment. If you are not able to settle with your employer or insurer and you take your case to trial, the court will not provide for lifetime amortization that may help maximize your workers’ comp benefits. This means that you’ll not be able to minimize the offset this way and will therefore be stuck with the permanent disability rate in your settlement.
How to Find Out if You Owe Taxes on Your Benefits
There are several ways through which one can determine whether they owe taxes. You’ll owe taxes on the amount provided to you in a W-2. This particular amount won’t reflect on your workers’ comp benefits. Any other benefits that may be treated as income may be reflected in this amount. Also, you can consult a workers’ compensation attorney if you have any questions concerning your tax liability after receiving workers’ comp benefits.
Other Tax Issued that Involve Workers’ Compensation
- Returning to Work
Most individuals who collect workers’ compensation benefits eventually return to work. Some even perform light work and earn wages while continuing to receive their workers’ compensation benefits. It’s important to note that any wages you earn while you’re still obtaining workers’ comp benefits for your injury are treated as taxable income.
For example, say you are a construction worker who suffers a work-related back injury. Your physician restricts you to no lifting more than 15 pounds and no overhead reaching. While you’re not able to return to your pre-injury job, your employer offers you an office position that does not involve lifting and pays you at your regular rate. The wages you earn in this light duty position are taxable. But if your employer pays you less for this light duty position, you’d be entitled to temporary disability benefits. Your disability benefits are not taxable but your light-duty earnings are.
- Social Security Retirement Benefits
Despite the fact that workers’ compensation benefits are typically not taxable, any retirement benefits you have received based on your years of services, age, or prior contributions are not exempt from taxation. This is applicable regardless of whether you have retired because of an illness or injury that brought about a workers’ compensation claim. However, the workers’ comp offset does not apply if you are receiving retirement benefits. Early retirement may provide you with a lower monthly Social Security payment but it’s good to consult with an attorney to see whether retiring early is worth it.
- Interest Payments
Sometimes, workers’ comp benefits are paid with interest, when the insurance provider was involved in egregious conduct or caused a considerable delay. If that’s the case, any interest paid is taxable.
If you’d like to learn more about tax implications for your workers’ compensation benefits, you’ll need to consult with a seasoned attorney as soon as possible. At Orange County Workers Compensation Attorney, we understand all of the relevant employment, personal injury, and workers’ compensation laws in California and can advise you as to your rights. And if you expect to receive your workers’ compensation benefits in addition to Social Security disability payments, we can draft a settlement that ensures you receive all the money you’re entitled to while minimizing or eliminating the workers’ compensation offset.