The short answer to that question is maybe! It all depends on who pays the premiums on the policy – you, your employer, or combination of both – and whether or not you pay the premiums with pre-tax or after-tax dollars. With employer-sponsored plans, those points aren’t always entirely clear.
Even if you have an individual disability policy, in which you pay 100% of the premium, there’s always the preference to take it as a tax deduction. But when it comes to disability insurance, there’s a major reason why you won’t want to take that deduction.
Employer Sponsored Disability Plans
The tax treatment of benefits under an employer-sponsored disability plan depends entirely upon who pays the premiums on the policy. If the employer pays the premium and does not include the cost of the premiums in your gross income, then the benefits you receive on a claim will be fully taxable.
On the other hand, if the employer merely makes a disability policy available to you, and you pay the entire premium without taking a tax deduction for it (after-tax), then the benefits received will be tax-free to you.
Things get more complicated when the premium is shared between the employer and employee. In that situation, the prorated share of the premium paid by the employer will be applied to the plan benefit, and will be taxable to the employee. However the percentage of the premium that is paid by the employee will mean that a matching percentage of the benefit can be received tax-free.
The key to the tax free benefit is of course that you are paying your share of the disability plan premium with after-tax dollars (no tax deduction when paid).
Cafeteria plans. These represent another gray zone when it comes to the taxability of disability benefits. With a cafeteria plan you can choose one or more of several employer sponsored benefits, one of which may be disability insurance. There are different ways these plans are structured. You normally would pay for a disability plan as part of a cafeteria plan with pre-tax dollars. Sometimes you pay the entire premium for a plan, and sometimes you split the cost of the plan with your employer. Your contributions can be either pre-tax or after tax, which affects the taxability of benefits in the case of a disability claim.
The portion of the premium paid by you with after-tax dollars means that that portion of your benefits on a disability claim will be tax-free. But if your employer pays for the premium, or if you pay with pre-tax dollars, that portion of the benefit will be fully taxable.
Individual Disability Plans
Generally speaking, benefits received under an individual disability plan aren’t taxable. This is because you pay the plan premiums with after-tax dollars, therefore premiums are not deducted on your income tax return. Since there is no tax benefit in paying for the policy, there is no tax liability on the resulting plan benefits.
Association plans. If you’re self-employed, you may be able to obtain a disability policy through a trade association. The Association will make such a policy available with benefits similar to a group plan. This usually includes such features as automatic acceptance into the plan and in the lower premium payments that a group plan brings.
However, since individual plans purchased through an association are paid by the individual, the tax treatment is the same as it will be for straight individual policies. That means that while the premiums paid will not be tax-deductible, the benefits received in a claim will not be included in your taxable income.
Social Security Disability Insurance (SSDI) Taxability
Many people who are permanently and completely disabled qualify for SSDI benefits. While these benefits are not usually taxed, they can be if you exceed certain income thresholds. Though SSDI benefits actually received are almost always below the taxable threshold, it is possible that other household income, particularly that of a spouse, could make the benefit partially taxable.
If you are single and have over $25,000 in total annual income, or if you are married filing jointly with a total annual income of at least $32,000, your disability benefits will be partially taxable.
On a monthly basis, taxability will become a factor if your income looks like this:
For individual tax filers:
Monthly income up to $2,083, 0% is taxable
Monthly income from $2,084 to $2,833, 50% will be taxable
Monthly income of $2,834 or higher, 85% will be taxable
For married couples filing jointly:
Monthly income up to $2,666, 0% is taxable
Monthly income from $2,667 to $3,666, 50% will be taxable
Monthly income of $3,667 or higher, 85% will be taxable
It’s important to understand that the percentage that is taxable is the amount of the benefit that must be added to your taxable income. The actual tax you will pay will depend on your marginal income tax rate. For example, if your marginal income tax rate is 15%, and your total monthly income is $4,000, 85% of your disability income will have to be added to your taxable income. If $2,000 per month – or $24,000 per year – is from SSDI, you will pay a tax of 15% of $24,000, or $3,600 per year ($300 per month) on the benefit.
Summing It All Up
Who pays your disability insurance premiums, you or your employer, and how you pay them – with pre-tax or after-tax dollars – determines whether or not benefits from the policy will be taxable to you. Considering that you could receive benefits totaling many thousand dollars on a long-term claim, you may want to bite the bullet by paying for the policy yourself, and by paying for the premiums with after-tax dollars.
That may mean missing out on a significant tax deduction in the current year, but the tax savings that it will produce in the event you make a claim will be substantial. It’s a choice between claiming it relatively small tax deduction now, versus enabling yourself to receive tax-free income in the event that you make a claim.
Disability insurance protects what may be your most valuable financial asset – your ability to earn a living. For that reason alone you need to have a policy in place. And when you do, make sure that you set it up properly, so that you will get the most tax benefit out of it.