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Is Long-Term Disability Insurance Taxable? What Policyholders Need to Know

Nothing is certain except death and taxes, but what about disability and taxes? More to the point: is long-term disability insurance taxable? The answer is… it depends. Whether you need to pay taxes on disability insurance benefits depends on how you paid for premiums. The right strategy can minimize your tax burden and boost your benefits.

Your Disability Insurance Benefits May Be Taxable

The IRS says that, if you have experienced a disability, you must report any income you received through an accident or health insurance plan paid for by your employer. If the amounts are taxable, you can either ask the insurance company to withhold income tax using Form W-4S or make estimated tax payments by filing Form 1040-ES. You pay estimated taxes quarterly, with payments due in April, June, September, and January.

If you pay for the entire cost of the insurance plan yourself, you don’t need to report any benefits you receive for your disability on your income taxes. However, it’s important to note that if you pay the premiums through a cafeteria plan and don’t include the premium as taxable income, the IRS says your employer is considered the payer, meaning you need to report the disability benefits you receive.

In other words, if your employer pays your premiums or you pay for the premiums with income that hasn’t been taxed, you need to report any disability benefits to the IRS and you may owe taxes.

Taxes Can Take a Big Bite out of Benefits

Imagine a woman named Brenda works as a senior architect at a medium-sized firm where she earns $120,000 a year. Her employer pays for a group long-term disability insurance policy, which replaces up to 60% of the workers’ regular income. Although surviving on only 60% of her pay would be a challenge, Brenda decides it’s feasible. Then, she becomes sick and needs to take time off work. She files a claim with the insurance company and, although it’s approved, she doesn’t receive the 60% she expected.

Firstly, the monthly benefit is capped at $5,000. Therefore, instead of receiving $6,000 a month, she only receives $5,000.

On top of that, she’s surprised to learn she has to pay taxes. After taxes, she’s only taking home about $47,000 a year and can’t keep up with her financial obligations. In retrospect, Brenda wishes she had purchased supplemental disability insurance coverage.

Not All Benefits Are Taxable

If you would rather not pay taxes on your disability insurance benefits, there is an option. H&R Block says disability insurance benefits are not taxable if you pay the premiums with after-tax dollars. This could be either an individual disability insurance policy you buy on your own without any involvement from your job or an employer-sponsored policy you pay for with after-tax dollars.

Essentially, you can pay taxes on the premiums or on the benefits. If you ever have to file a claim, the taxes you owe on your benefits could be far greater than the taxes you owe on the premiums. If you want to maximize your benefits and minimize your tax burden, this is something to be aware of.

It’s also a good reason to buy individual disability insurance. Even if your employer offers and pays for group long-term disability insurance coverage, you may need more coverage.

Employers Should Consider Their Tax Burden, Too

Employees aren’t the only ones who want to reduce their tax bill. When employers pay for disability insurance premiums and other benefits, they may be able to deduct the cost. IRS Code 162 may be of particular interest to employers who are trying to compensate their top employees while protecting the company’s bottom line. This tax rule allows employers to provide funds for life and disability insurance to executives while enjoying tax deductions.

Keep in mind, though, that if the employer is paying for the premiums, the benefits may be subject to taxes, as explained above.

The Bottom Line

Taxes can be complicated, especially when benefits are involved. In addition to federal taxes, workers and employers need to consider state tax rules. As individual situations may be different, you should consult a tax expert if you have questions about your taxes.

However, policyholders, employers, and their insurance agents should be aware of the general issues. Knowing the basic rules of when disability insurance benefits are taxable can help you create a tax strategy that includes disability insurance.