Many Americans rely on disability income. Are you one of them, or might you be in the future? If so, you may be wondering: Is this income taxable, and if so, how is it taxed? The answer depends on the type of disability benefit you receive and your total income.
The key factor is who paid for the benefit. If your employer pays you directly, that income is taxable, just like your regular salary. (Taxable benefits are also subject to federal income tax withholding, though some employer disability plans may not require Social Security tax withholding.)
Often, the payments come from an insurance company under a disability insurance policy, rather than directly from an employer. In other situations, the payments may come from a plan that functions like accident or health insurance. In these cases, the tax treatment depends on who paid for the insurance. If your employer paid, the benefits are taxable to you as if the employer had paid you directly. However, if you paid for the policy yourself, the benefits are not taxable.
Even if your employer facilitates the coverage (for example, by offering a plan through work), the benefits are not taxable if you, not your employer, paid the premiums. If your employer pays the premiums but the amount is included in your taxable income, the premiums are considered paid by you, meaning the benefits won’t be taxed. The taxability of the benefits you receive hinges on whether the premiums were taxed when they were paid.
Let’s look at an example.
Suppose you earn $1,050 per week ($54,600 per year). Your employer arranges a disability insurance plan and pays $15 per week ($780 per year) in premiums to the insurance company. If you include $55,380 in your taxable income for the year (your $54,600 salary plus the $780 in premiums), the insurance is treated as being paid for by you. Therefore, if you become disabled, the benefits would not be taxable.
Now, assume you only report $54,600 in taxable income because the premiums qualify as excludable under employer-provided health and accident plan rules. In this case, the insurance is treated as paid for by the employer, so if you become disabled, the benefits would be taxable.
There are special rules for permanent loss or loss of use of a body part or function, or for permanent disfigurement. In these cases, employer-provided disability payments are not taxed, as long as they are not based on time lost from work.
Social Security Disability Benefits:
This discussion does not cover Social Security Disability Insurance (SSDI) benefits. SSDI may be taxable under the rules that govern Social Security benefits. A portion of SSDI may be taxable if your income exceeds $25,000 for individuals or $32,000 for married couples.
State Taxes:
Your state may or may not tax disability benefits, so it’s important to check your state’s rules. Reach out to us to discuss your specific situation.
When deciding how much disability coverage you need for yourself and your family, be sure to consider the tax implications. If you’re purchasing a private policy, you only need to replace your after-tax income, since the benefits won’t be taxed. However, if your employer is covering the premiums, keep in mind that part of the benefits may go to taxes. If your current coverage is insufficient, you might want to consider supplementing it with your own private policy.