Many Americans receive disability income. If you’re one of them or know someone who is, you may wonder whether it’s taxable. As is often the case with tax questions, the answer is “it depends.”
KEY FACTOR
The key factor is who paid it. If the income is paid directly to you by your employer, it’s taxable to you as ordinary salary would be. Taxable benefits are also subject to federal income tax withholding – though, depending on the disability plan, they sometimes aren’t subject to Social Security tax.
Even if your employer arranges for the coverage (in other words, it’s a policy made available to you at work), the benefits aren’t taxed to you if you pay the premiums.
Frequently, the payments aren’t made by an employer but by an insurer under a policy providing disability coverage or under an arrangement having the effect of accident or health insurance. In such cases, the tax treatment depends on who paid for the coverage. If your employer paid for it, the income is taxed to you, as if paid directly to you by the employer. But if you paid for the policy, the payments you receive under it aren’t taxable.
Even if your employer arranges for the coverage (in other words, it’s a policy made available to you at work), the benefits aren’t taxed to you if you pay the premiums. 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.
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 disable and receive benefits, they are taxable income to you.
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 a policy you take out personally.
ANY QUESTIONS
This discussion doesn’t cover the tax treatment of Social Security disability benefits, which may be taxed under different rules. Contact us to discuss this further or if you have questions about regular disability income.