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Taxation of Disability Benefits

Spring 2011

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Disability Insurance Benefit Payments

For private disability benefits, the IRS looks to tax either the premiums paid for the disability insurance or the benefits paid to the claimant, but not both. This can best be explained by example:

  • A person buys individual disability insurance from an insurance company. He/she pays the premiums with after-tax dollars, that is, the premiums are not deducted from taxable income as a business expense or otherwise. Because the premiums were included in taxable income, any benefits that person receives from the policy due to disability are not income taxable.
  • An employer provides short term and long term disability to all eligible employees, and provides them as an employee benefit without cost to the employees. Because the employer deducts such payments from its income as a business expense, the premiums are not taxed so any disability benefits received by disabled employees are fully income taxable.
  • An employer provides, without cost to the employees, a long term disability plan that pays 50% of their salary if disabled. Each employee has the right to additionally purchase, through payroll deduction, an additional 16-2/3% benefit to bring the total disability benefit up to 66-2/3% of income. The employee's portion of the premium withheld from the paycheck is included in the W-2 earnings and therefore taxable. In this case, the disability benefits are taxable in proportion to how the premiums were paid. Since the employer deducted the premiums for its coverage, any benefits received from that portion of the plan would be taxable, however, the benefit that comes from the portion the employee purchased with after tax dollars would be income tax free.
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Some employers who usually purchase long term disability for their employees will allow employees to elect to pay for their long term disability coverage with after tax dollars through payroll deduction, just for the purpose of making any future disability benefit payments tax free. If your employer offers this alternative, it is recommended that you seriously consider taking advantage of it. Having disability benefits income tax free can greatly enhance the quality of life when income is already lowered by the disability itself.

It should be noted that there is a three year look back period to this rule. This means that once you have paid the premiums with after tax dollars for three years, your benefits will be entirely tax free. If, however, you become disabled before the three years expires, your benefits will be taxable in the same proportion as the premiums paid. If you had paid the premiums for only one year and your employer paid the two prior years, only one-third of the benefit would be tax free. These rules apply to both short-term and long term disability.

As you can see from the explanations above, the taxation of disability benefits whether from Social Security or private insurance is a complicated issue. People starting to file taxes for the first time while on disability should either retain experienced tax counsel or take advantage of one of the many programs that offer free income tax assistance.

Jacques Chambers, C.L.U., is a benefits counselor in private practice with over 35 years experience in health, life and disability insurance and Social Security disability benefits. He can be reached by phone at 323.665.2595, by e-mail at jacques@helpwithbenefits.com, or through his Web site at www.helpwithbenefits.com.

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This article was provided by Being Alive. It is a part of the publication Being Alive Newsletter. Visit Being Alive's website to find out more about their activities, publications and services.
 
See Also
More on Social Security Disability Insurance and HIV/AIDS

 

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