This week, Gail discusses the matter of workers’ compensation, which can be taxed when it “looks” like Social Security.

Dear Friends,

If you are injured on the job and unable to work, the workers’ compensation you receive is tax-free, right?

Not necessarily.

As Sandra Flores found out this month, if you are also collecting disability under Social Security, this can cause your workers’ comp to be taxed.

Flores was seriously injured on the job in 2000. She began collecting workers’ compensation in November of that year. Her employer’s long-term disability insurance plan required that she apply for Social Security disability benefits once she had collected workers’ comp for a year.

In 2001, Flores received the following income:

Social Security disability: $8,820
Workers’ Compensation: 11,855
Total: $20,675

When she and her husband filed their 2001 income tax return they listed the above income, but said $11,855 was not taxable because it consisted of workers’ compensation.

According to Martin Nissenbaum, director of Personal Income Tax Planning for Ernst and Young, in general “workers’ comp is not taxable because it’s for a personal injury.”

In other words, the government isn’t going to add insult to your injury by taxing you on this money.

Usually.

In the case of Flores, she was eligible for $20,675 in Social Security disability benefits. But this was reduced (offset) by what she received in workers’ compensation insurance. (You’re not entitled to the full amount of both.)

The Tax Court pointed out that Section 86(d)(3) of the Internal Revenue Code specifically addresses these circumstances. The law is very clear: when Social Security benefits are offset by workers’ compensation benefits, the IRS has to treat the entire amount — $20,675 — as if it came from Social Security.

Unlike workers’ compensation, Social Security benefits — whether they’re for disability or retirement — may be taxable.

This isn’t as diabolical as it sounds. The purpose of this law is to make sure everyone is treated equally. If it didn’t exist, people who only qualify for disability payments — with the entire benefit coming from Social Security — would potentially pay more tax than someone whose income was partly from Social Security and partly from workers’ comp.

What? You didn’t think Social Security disability payments were taxable? Wrong. They’re subject to the same rules as Social Security retirement benefits.

As any retiree can tell you, whether or not you pay income tax on your Social Security benefits depends upon a number of factors: your filing status (single? married filing jointly? etc.), the amount of Social Security you receive, and the other income you have, including interest from municipal bonds. If this amount exceeds the “threshold” for your filing status, up to 85 percent of your Social Security benefit is taxable.

It doesn’t matter whether the Social Security check you receive is a disability benefit or a retirement check. As Nissenbaum points out, “you get the same tax form” from the Social Security Administration — “SSA 1099” — regardless of the type of benefit you receive.

To figure out if any of your Social Security benefits are taxable, let’s look at an example:

Mr. and Mrs. Smith are retired and are both collecting Social Security. He received $10,000 in benefits last year and she received $7,000. In addition, they earned $500 in interest on various bank accounts, $800 in municipal bond interest, $15,000 from her company pension, and $9,500 from his part-time job.

To determine if the Smiths will have to pay income tax on any of their Social Security benefits, you have to do a special calculation. Simply add up:

50 percent of all Social Security benefits
+ All Other Sources of Income (including savings bond and municipal bond interest.)

This is called your “provisional income.”

If you’re married and file jointly, none of your Social Security is taxable as long as this amount is under $32,000 ($25,000 for single taxpayers).

If your provisional income exceeds the above amount, but is under $44,000 ($34,000 for single taxpayers), 50 percent of your Social Security benefits is added to your other income and is taxed at whatever tax bracket you fall into.

If your provisional income is greater than $44,000 ($34,000 for single taxpayers), 85 percent of your Social Security benefit is taxed.

Let’s look at the Smiths:

50 percent Social Security benefits: $8,500
All other income: 25,800
Provisional Income: $34,300

Because the Smith’s provisional income is more than $32,000, 50 percent of their Social Security benefits ($8,500) will be subject to income tax.

What I really object to about the taxation of Social Security benefits is that the threshold amounts have never been adjusted for inflation. The 50 percent level was set more than 20 years ago (1983); the 85 percent threshold was established during the first Clinton administration.

Since Social Security benefits get increased each year based on inflation, having fixed thresholds means more and more people are finding that their Social Security benefits are subject to tax. This is one of those stealth taxes like the AMT: conveniently, members of Congress don’t have to go on record and vote to increase the amount of tax collected. It happens automatically.

According to the IRS, in 1985, $9.6 billion in Social Security benefits fell into the “taxable” category. Ten years later, Americans paid income tax on $45.7 billion in Social Security payments. In 2002, the latest year for which the data is available, roughly $93.5 billion in Social Security benefits were taxed.

If you assume that the recipients of these payments were all in the 15 percent tax bracket (which is lowballing this because an unknown number of taxpayers were subject to higher tax rates), this means the amount of tax the government collected on Social Security benefits that year was …

$14 billion.

Now I understand what my husband’s Aunt Jay used to rail about. She was single and had a government pension so her retirement income was over $25,000 per year. Therefore, by government standards she was a “wealthy” senior and half her Social Security income was taxed. You could always ignite the Thanksgiving dinner conversation by asking Aunt Jay to explain how she was being taxed on taxes (Social Security) she had paid.

As crazy as it sometimes gets, I still think this is the best country in the world,

Gail.

P.S. If you receive Social Security benefits of any kind, you should have a copy of IRS Publication 915. You can access it online at www.irs.gov.

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