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Disability Proceeds – Taxable or Tax-free? It depends!

If you are someone who recently began receiving disability income you may have asked yourself the question, how will this be taxed?

To determine the answer to this question you must first consider the following:

The first thing to consider is: who paid for the benefit? If your employer pays the disability income to you directly, it is taxable just the same as your ordinary salary. (Benefits that are taxable are subject to federal income tax withholding. In some cases, these benefits are not subject to Social Security tax depending on your employer’s disability plan.)

Typically, disability payments are paid by an insurance company under a disability coverage policy rather than by an employer. In some cases, payments are paid under an arrangement resulting from an accident or health insurance. The tax treatment of these payments depends on whether you or your employer paid for the insurance coverage.

If paid by your employer, the benefit is taxed just as if the employer paid the money to you directly.

For example, an employee is paid $1,000 a week ($52,000 a year). Their employer offers a disability insurance plan in which the employer pays $10 a week ($520 a year) on the employee’s behalf to the insurance company. The employee includes $52,000 as income from wages for the year. The $10 a week for disability insurance qualifies as excludable under the rules for an employer-provided health and accident plan. In this case, the insurance premiums are treated as paid for by the employer. If the employee were to become disabled and receive disability benefits from this policy, these benefits would be taxable income to the employee.

If you paid for the policy, the benefit is not taxable. Scenarios in which the coverage is considered paid by you and the benefit would not be taxable include:

  • Coverage arranged by your employer (in a policy made available to you by your employer), in which you pay the premiums.
  • Premiums are paid by your employer, but the premium amount paid is included in your taxable income.

For example, consider the same details as above but instead, the employee includes $52,5250 ($52,000 salary plus $520 of disability insurance premiums) as income from wages for the year. In this scenario, the insurance premiums are treated as being paid by the employee because they are included in his income for the year (i.e., paid with “after-tax” dollars). If the employee were to become disabled and receive disability benefits from this policy, these benefits would be tax-free to the employee.

Additionally, there are special rules in place for situations in which an employee experiences permanent loss or use of a member or function of the body or permanent disfigurement. In this case, as long as the employer’s disability payments are not computed based on the time lost from work, they are not taxable.

Considering Coverage

When deciding how much disability coverage you need to protect you and your family you should consider the tax treatment. If you’re making the premium payments yourself, you only need a policy to replace your after-tax income, as these benefits will not be taxed. If your employer is paying for the benefit you will need to consider the portion of the benefit that will be lost to taxes. If your current coverage is not sufficient for your needs, you may want to consider supplementing your employer-provided benefit with an additional policy that you take out on your own.

Contact us at Wegner CPAs if you would like to further discuss the tax aspects of your disability income or the coverage you may need.

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