Understanding the Tax Implications of Disability Income Benefits

INDIVIDUAL TAX | 07/07/2024

For many Americans, disability income provides essential financial support during challenging times. If you currently receive or expect to receive disability benefits, it’s important to understand how they’re taxed. The tax treatment depends on the type of benefit and, most importantly, who paid for the coverage.

Key Consideration: Who Paid for the Benefit?

The taxability of disability income hinges on who covered the cost of the benefit:

1. Employer-Paid Benefits
   • If your employer pays for the disability benefits, the income you receive is taxable, just like your regular salary.
   • These benefits may also be subject to federal income tax withholding, although they are often exempt from Social Security tax depending on the employer’s disability plan.
2. Employee-Paid Benefits
   • If you pay for the disability insurance policy with after-tax dollars, any benefits you receive are not taxable.
   • Even if your employer arranges the policy, as long as you pay the premiums or the premiums are included in your taxable wages, the benefits are considered paid by you and remain non-taxable.
3. Shared Responsibility
   • If both you and your employer contribute to the policy premiums, the tax treatment of benefits will be proportional. Benefits attributable to your employer’s contributions are taxable, while the portion funded by you remains tax-free.

Illustrative Example

• Scenario 1:
  Your employer pays $780 annually toward your disability insurance policy, and this amount is included in your taxable wages. Since the premiums are treated as paid by you, any benefits you receive under the policy will be tax-free.
• Scenario 2:
  Your employer pays $780 annually toward your disability insurance, and this amount is excluded from your taxable wages. In this case, the premiums are considered paid by your employer, making any benefits you receive under the policy taxable.

Special Cases

• Permanent Loss or Disfigurement:
  If disability payments are tied to a permanent loss of a body part or function or to permanent disfigurement, these payments are generally not taxable, provided they aren’t based on time missed from work.
• Social Security Disability Insurance (SSDI):
  SSDI benefits follow different tax rules. A portion of these benefits may be taxable if your income exceeds $25,000 (individuals) or $32,000 (married couples filing jointly).

State Tax Considerations

State rules for taxing disability benefits can vary widely. Some states may tax disability benefits, while others do not. Consulting a tax professional familiar with your state’s regulations is essential.

Planning for Disability Coverage

When evaluating your disability insurance needs, consider the tax treatment of your benefits:

• If you purchase a private policy with after-tax dollars, you only need to replace your after-tax income because your benefits won’t be taxed.
• If your employer provides disability coverage, remember that you’ll lose a percentage of the benefits to taxes. If necessary, consider supplementing your employer’s coverage with a private policy to ensure adequate protection.

How We Can Help

Navigating the tax treatment of disability income can be complex, particularly when factoring in federal, state, and Social Security rules. Our tax professionals can:

• Assess the tax implications of your disability benefits.
• Help you plan for sufficient disability coverage to meet your financial needs.
• Clarify state-specific taxation rules and offer tailored advice.

Contact us today to ensure your disability income strategy aligns with your financial goals and tax obligations.