Disability Insurance and Taxes

Generally, all income you get is taxable income unless it's expressly exempted. Exemptions include workers' compensation payments, and personal injury settlements received through litigation.

But income received from disability insurance generally isn't exempt. Insurance companies provide these benefits, and they may or may not be subject to income tax.

Whether disability insurance benefits are taxable depends on:

• The type of benefits you get
• Whether the premiums were paid with pre-tax or after-tax dollars
• Who paid the premiums

Individual Disability Insurance

In an individual disability insurance plan, because you pay the premiums with after-tax dollars, the disability policy benefits you get are tax-free. Unlike health insurance premiums, you can't deduct premiums paid for individual disability coverage as a medical expense. Because disability insurance provides for income replacement rather than medical care, it is not deductible on your tax return as a medical expense.

Disability Insurance for Self-Employed People

When you work for yourself, there's no big company to give you paid sick days or help if you're out for a long time. If you can't work, you might not make any money. Disability insurance can help replace some of that lost income.

Being self-employed is like being the captain of your ship. But, like a ship needs lifeboats for safety, you need a disability plan in case things go wrong. As a taxpayer, if you pay for it with your own money, the disability income you get from it later doesn't get taxed. It's a smart choice for people who work for themselves.

Employer-Based Disability Insurance

In an employer-based disability insurance plan, whether the benefits you get are taxable depends on who pays the premiums. If you pay the total premium using after-tax income, your benefits aren't taxable.

But if your employer pays the total premium and doesn't include the cost of coverage in your gross income, your benefit amounts are taxable. Following these general rules, the type of dollars used to pay the premium determines whether your benefits are taxable:

• If your employer pays part of the disability insurance premium and you pay the rest, you'll split your tax liability.
• If you pay your part of the premium with pre-tax dollars, you'll pay taxes on any benefits you receive related to that part of the premiums.
• If you pay your part of the premium with after-tax dollars, you will not pay taxes on any lump sum benefits you get related to that part of the premium.
• If your employer doesn't deduct its part of the premium from your pay, you'll pay taxes on any benefits you get related to that part of the premium.

Understanding Short-Term vs. Long-Term Disability

Short-term and long-term disability insurance is like two helpful friends when you're going through a tough time. When you get sick or injured and can't work, short-term disability steps in as a quick helper.

These disability payments give you a part of your usual pay. They act like a friend lending you some money until your next allowance. Typically, this help lasts for a short time, from a few weeks up to a year.

If your job offers and pays for this insurance, the money you get is often taxed just like your regular paycheck. But if you buy it yourself using your own after-tax money, the benefits you get are usually tax-free.

Long-Term Disability

As the name suggests, long-term disability is there for the long haul. If you're unable to return to work after your short-term coverage ends, long-term disability takes over like a backup plan.

Long-term disability ensures you still have something to rely on. This coverage can extend for several years, sometimes even lasting until you retire.

The tax situation for long-term disability is like short-term. If you pay for it with your own after-tax money, the benefits you receive typically aren't taxed. But if your employer provides and pays for it, the benefits you receive will likely be subject to taxes.

In essence, both these insurance policies offer a safety net for challenging times. Whether it's a brief setback or a long-term issue, they provide a financial cushion to help you manage. The tax implications of the benefits largely depend on who's footing the bill for the coverage: you or your employer.

Cafeteria Plan

An employer-based cafeteria plan allows employees to select coverage from a menu of options. This includes health insurance, life insurance, and disability insurance.

Most often, you'll pay for this coverage with pre-tax dollars. But, sometimes, your employer may pay the premium for coverage you choose up to a certain amount.

If you choose more coverage, you may pay for the extra coverage with pre-tax or after-tax dollars. If you pay your part of the premium with pre-tax dollars, you'll pay taxes on any benefits you get related to that part of the premium. If you pay your part of the premium with after-tax dollars, you generally won't pay taxes on any benefits you get related to that part of the premium.

State Disability Insurance

Benefits you get through a state disability insurance program may or may not be taxable. In California, disability benefits aren't taxable unless the benefits are in substitution for unemployment insurance. In other states, such as New York and New Jersey, disability benefits are taxable. In those states, employers pay for a part of the benefits.

Consider Meeting With a Disability Attorney

Disability benefits are typically needed the most when we're feeling the worst. Who has the energy to deal with the IRS and their tax treatment? Even the most competent claimants need professional legal advice.

If you have questions about disability insurance, potential exclusions, or paying taxes, speak with a disability insurance claims attorney.