During this time of year, many people have questions about the tax effects of their disability benefits and how they can be reported on their tax returns. Many of these questions are addressed by one of our partners, who’s a Certified Public Accountant. These answers may help you with some of the issues that may come up with your benefits and the related income taxes.
Q: Are LTD benefits taxable?
CPA: This is a question I deal with all the time, as the answer isn’t that simple. 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 premiums were paid with untaxed or pre-tax income, then the benefits are taxable. So 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 them being expensed, so the disability benefits will be taxable.
Q: That’s good to know, but I purchased my policy independently of my employer. How does this change the situation?
CPA: It’s a similar situation for self-employed individuals who write-off their disability insurance premiums as business expenses – their benefits will be taxable as well.
The opposite is true when you purchase 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 essentially been paid on the premiums so benefits will be received tax free. Obviously this is very beneficial if you end up becoming disabled and successfully obtain your benefits. But the randomness of who may become disabled at what time prevents anyone from knowing this with any certainty. To go back to the last question, if employers pay their disability insurance premiums with their employees’ after-tax dollars even in the employer-based plan, 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 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, only 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. It’s always a good idea to have a trained financial or tax professional review your benefits and help you report and file in the best manner for your situation.
Q: I finally received my Social Security benefits, but I had to repay them to my private insurer as part of my LTD policy provisions. How can they require that?
CPA: This is a complicated question that really requires the help of an accountant – wait, that’s me! Let me try and explain the basics of the accounting here through an example:
Jim’s disability policy called for $3,000/month in benefit payments. He was also eligible to receive $1,000/month in Social Security disability insurance. According to his policy provisions, the insurance company would initially send him the full $3,000/month, but offset the benefit amount by any SSDI he (and his dependents) would receive from Social Security. Although both Social Security and private insurance combined should add up to your benefit amount, it’s not that simple. Since most working Americans are eligible for SSDI coverage, there are many more people eligible for SSDI benefits than have their own long term disability insurance. Social Security has a huge backlog of claims, and SSDI claims generally take much longer to get approved than claims submitted to an insurance company. Since benefits from the insurance company are offset by Social Security benefits, the insurance company pays the full monthly benefits under the policy language, since there are no Social Security payments – yet. So if Jim’s policy provided for $3,000 of monthly benefits and Social Security benefits hadn’t been approved or paid yet, the disability insurance company would pay the whole $3,000 per month.
However – and this is HUGE – when Social Security SSDI benefits are finally approved and paid to Jim, he’ll receive a lump sum check for all of the benefits he’s owed, retroactive to the date he became disabled. If 3 years had elapsed from the date of disability until SSDI benefit payments were made by Social Security, then Social Security would send a check for $36,000 (36 months x $1,000 per month). The timing of these payments doesn’t change the policy contract with the disability insurance company. Now that the insured has received his Social Security benefits retroactively, the insurance company overpaid the benefits for 3 years by $1,000 per month…and they’ll want that money back! To the extent required under the policy, Jim is obligated to turn over his SSDI benefits to the insurance company.
Q: So now that I’ve repaid all of my Social Security benefits to the LTD company, the IRS is saying I owe income taxes on these benefits! But my LTD benefits weren’t taxable! How can this be right?
CPA: This is probably the most common question I get here at the firm – and this is where the tax reporting process gets the most confusing to claimants. The tax code provides that you don’t have to pay taxes on benefits you don’t receive – it’s referred to as a right of claim. So, if all of the SSDI benefits were reimbursed to the insurance company, those SSDI benefits weren’t actually received. Another way to think about our above example is that the insurance company essentially loaned Jim $24,000 that Jim has to repay with his retroactive SSDI award. Between Social Security and disability insurance benefits, Jim should have received a total of $72,000 over the two years: $24,000 from Social Security and $48,000 from the private disability insurer. But the insurance company paid the entire $72,000 over those 24 months. Once Social Security eventually caught up on their part and paid the retroactive award, the insurance company expects those payments to be repaid.
Social Security issues 1099 forms for SSDI benefits payments, so those amounts have to be accounted for on the income tax return. There are ways to account for these payments in order to avoid taxes on the SSDI benefits that were repaid to the insurance company. One way to report these benefits is by using the “right to claim” rule. This rule may enable you to take a deduction on Schedule A, Itemized Deductions. If you normally itemize to begin with, there may be other limitations to this method. Again, I cannot stress enough how important it is to hire an experienced tax professional to help you with these matters considering your own particular circumstances.
Q: I talked to an accountant, and I’m not eligible to use this method to report my repayments. Do I have any other options?
CPA: If you have restrictions that prevent you from using the previous method, you may have two other options. You can amend the prior years’ returns and reduce the reported income from the insurance company (if any) and increase the Social Security benefits attributable to and reported in that year (i.e., $12,000 per year for the two prior years in our example). A second option involves calculating income tax credits on a pro-forma basis on the current year’s tax return for the income attributable to prior years, known as the lump sum method. For either approach, I strongly recommend the help of an experienced financial or tax professional or a disability claims advocate who has experience dealing with financial reporting issues in disability claims.
As you can see, the tax issues involved in reporting your disability benefits can be very confusing. While there are solutions that can help report benefits correctly and accurately, it’s very important that you have specialty-experienced professional help with these issues. Otherwise, you may end up paying more taxes than you actually owe – plus interest and penalties which add up quickly. I would like to thank our very own CPA consultant for taking the time today to answer these questions. If you would like to speak with us regarding any specific concerns about the tax reporting of your benefits, feel free to call our offices at (855) 828-4100 or visit our website to sign up for a free consultation.