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November 11, 2021 •HoganTaylor
Many Americans receive disability income, and the question is often asked: Is it taxable? The short answer is: That depends on who bought the coverage. This article details how and when taxes may apply. A sidebar discusses how much disability coverage an individual may need.
Key factor
The key factor is who paid for the coverage. If the income is paid directly to you by your employer, it’s taxable to you as ordinary salary, subject to federal and state income tax withholding. Dependent on the disability plan, the payments may subject to Social Security tax. Payments under a workmen’s compensation policy are not taxable.
For payments made by an insurer under a disability policy or an accident or health policy., the taxability is determined by source for the premium payments. If your employer paid for it, then the income is taxed to you just as if paid directly to you by the employer. If you made the payments from pre-tax wages (cafeteria plan), the income is taxable. On the other hand, if it’s a policy you bought with after tax dollars, the payments you receive aren’t taxable.
Your employer can arrange for the coverage at work., The benefits taxability is based upon source of the premium payments. If the premiums are withheld from your salary, pre-tax, the insurance proceeds will be taxable. If premiums are paid by you, after taxes, payments aren’t taxed to you. For these purposes, if the premiums are paid by the employer but the amount paid is included as part of your taxable income from work, the premiums are treated as paid by you and not taxable
Two examples
Let’s say your salary is $1,000 a week ($52,000 a year). Under a disability insurance arrangement made available to you by your employer, $10 a week ($520 for the year) is paid on your behalf by your employer to an insurance company. You include $52,520 in income as your wages for the year: the $52,000 paid to you plus the $520 in disability insurance premiums. In this case, the insurance is treated as paid for by you. If you become disabled and receive benefits, they aren’t taxable income to you.
Now, let’s look at an example with the same facts as above. Except in this case, you include only $52,000 in income as your wages for the year because the amount paid for the insurance coverage qualifies as excludable under the rules for employer-provided health and accident plans. In this case, the insurance is treated as paid for by your employer. If you become disabled and receive benefits, they are taxable income to you.
Note: There are special rules in the case of a permanent loss (or loss of the use) of a part or function of the body, or a permanent disfigurement.
Any questions?
This discussion doesn’t cover the tax treatment of Social Security disability benefits, which may be taxed under different rules. Contact us if you’d like to discuss this further or have questions about regular disability income.
Sidebar: How much coverage is needed?
In deciding how much disability coverage you need to protect yourself and your family, take tax treatment into consideration. If you’re buying the policy, you need to replace your after-tax, “take-home” income because your benefits won’t be taxed. On the other hand, if your employer pays for the benefit, you’ll lose a percentage to taxes. If your current coverage is insufficient, you may wish to supplement an employer benefit with another policy.
If you have any questions about the content of this publication, or if you would like more information about HoganTaylor's Tax practice, please email Tony Otto, Tax Practice Lead, at jotto@hogantaylor.com. You may also contact Denise Felber, Tax Partner, at dfelber@hogantaylor.com
INFORMATIONAL PURPOSE ONLY. This content is for informational purposes only. This content does not constitute professional advice and should not be relied upon by you or any third party, including to operate or promote your business, secure financing or capital in any form, obtain any regulatory or governmental approvals, or otherwise be used in connection with procuring services or other benefits from any entity. Before making any decision or taking any action, you should consult with professional advisors.