It’s tax time again and many people are now realizing the large tax bills that disability benefits can cause. We are getting many questions about disability insurance and how it relates to income taxes and retroactive Social Security awards. We have so much to talk about, we decided to turn this article into a three-part series over the next few days to break up the information into more manageable sections. Today, I am going to be discussing how disability insurance relates to your taxes as well as how you can lessen any tax burdens caused by your benefits.
There are several ways that disability insurance premiums and benefits can be paid or structured that effect their taxability. The three possible methods to pay disability insurance premiums are premiums paid by an employer, premiums paid by an employee, and premiums that are a combination of employer and employee contributions.
Disability insurance is always taxed, it just depends on whether taxes are paid on the premiums or the benefits – think of it a little like a see-saw. If income taxes were paid on premiums, then benefits are tax-free. If income taxes were not paid on premiums, then benefits are taxable. When an employer includes short-term and long-term disability insurance as part of an employer-sponsored benefit package, the premiums for these coverages are usually expensed and deducted from income by the business. In such a case, no taxes are paid on the premiums by virtue of being expensed, so the disability benefits will be taxable if they are ever paid. It is a very similar situation for self-employed individuals who write-off their insurance premiums as business expenses – their benefits will be taxable as well.
The opposite is true if you have purchased disability insurance out of your own pocket or are self-employed and didn’t include the premiums in your business expenses. Since these premiums were paid with post-tax dollars, taxes had been paid on the premiums so benefits will be received tax free! Obviously this is more beneficial but only if you end up becoming disabled and successfully obtain your benefits. The randomness of who may become disabled at what time prevents anyone from knowing this with any certainty. If employers have their employees pay their own disability insurance premiums with post-tax dollars even in the employer-based plan, any benefits will not be taxable.
The third category of involves a combination of employer and employee contributions to the total premiums for a plan. In these cases, the benefits are taxable in proportion to the percentage of the total premium that were paid by pre-tax dollars as opposed to post-tax dollars. For example, let’s say the monthly premium total of a disability insurance policy is $100. The employer pays $75 and records that as a business expense while the the employee contributes $25 after taxes as a post-tax deduction on their paycheck. 75% of the premium is paid with pre-tax dollars by the employer and 25% is paid with post-tax dollars by the employee. If the insured employee becomes disabled and receives $2,000 per month of benefits, 75% of those benefits, or $1,500 per month, are taxable. Obviously, these types of arrangements can become more complicated depending on how premiums were paid by which parties and how those premiums were reported.
Taxes are a big concern for many people who receive disability benefits, especially since April 15th has just come around and people are doing their tax returns. The basic relationship between premiums and benefits is relatively straight-forward. In the next post, I will be discussing how back SSDI benefits paid by Social Security affect your disability insurance claim and your taxes. There are some facts that the insurance company or your accountant may fail to mention that can help save you thousands of dollars in taxes! Check back on Wednesday for the next post in the series. Until then, call us at 855.828.4100 or visit our website if you need disability claim help to sign up for a free consultation.