Tax planning tips: Disability insurance

The income you receive from disability income insurance may or may not be taxable. The taxability of disability income insurance benefits depends on what type of benefits you receive, whether the premiums were paid with pretax or after-tax dollars, and who paid the premiums (you or your employer).

Individual disability income insurance

The rules surrounding taxation of individual disability income insurance benefits are generally simple. Because you pay the premiums with after-tax dollars, the benefits you receive are tax free. However, unlike health insurance premiums, you can't deduct premiums paid for individual disability income insurance as a medical expense.

Sometimes, your employer pays for an individual disability insurance policy on you. This may be the case if you are considered to be a key employee of the business. If so, different rules may apply. If the employer gets the benefit, then the premium is not deductible to the company, and the benefit is not taxable when received by the company.

Employer-sponsored group disability insurance

If you are enrolled in a group disability insurance plan sponsored by your employer, the taxability of your benefits depends on who pays the premium. If you pay the total premium using after-tax income, then your benefits will be tax free. On the other hand, if your employer pays the total premium and does not include the cost of coverage in your gross income, then your benefits will be taxable.

If your employer pays part of the insurance premium and you pay the rest, then your tax liability will be split as well. The part of the benefit you receive that is related to the employer-paid share of the premium is taxable; any part of the benefit related to your share of the premium is tax free.

If you pay part of the premium for employer-sponsored disability coverage, the type of dollars you use to pay the premium determines whether your benefit will be taxable. If you pay your part of the premium with pretax dollars, through a cafeteria or medical reimbursement plan, you'll owe income tax on any disability benefit you receive that is related to that part of the premium. On the other hand, if you pay your part of the premium with after-tax dollars, you won't owe income tax on any disability benefit you receive that is related to that part of the premium.

Benefits under a cafeteria plan

An employer-sponsored cafeteria plan allows you to select among certain employee benefits, including health, life, and disability insurance. You normally pay for these benefits on a pretax basis. Sometimes, however, your employer pays the premium for the benefits you choose (up to a certain amount), and if you choose additional benefits, you pay for extra coverage using either pretax or after-tax dollars.

If you pay your share of the premium with after-tax dollars, that portion of your disability benefits will be considered tax-free income; you'll be taxed only on the portion of the benefit related to your employer's contribution. However, if you pay your share with pretax dollars, that portion of your disability benefits will be considered taxable income, and you'll have to pay income tax on all of your benefit.

If you are totally and permanently disabled, and you receive fully or partially taxable disability benefits from an employer-sponsored disability insurance plan, you may be eligible to claim a tax credit when you file your annual income tax return.

Group association disability insurance

Disability policies purchased through an association are called group policies because members of the association are offered special terms, conditions, and rates based on the characteristics of that group. Association policies function much like individual policies and have similar tax consequences. If you pay the premiums for an association policy, the benefits you receive are tax free, but you cannot deduct the cost of the premiums.

Government disability insurance

All, part, or none of the disability benefits you receive through government disability insurance programs may be taxable. How much of the benefit is taxable (and under what circumstances) depends on the type of government disability benefit you are receiving:

Social Security benefits: If the only income you had during the year was Social Security disability income, your benefit usually isn't taxable. However, if your total income exceeds a certain base amount and you earned other income during the year (or had substantial investment income), then you might have to pay tax on part of your benefit. More specifically, your Social Security benefit is taxable if your modified adjusted gross income plus one-half of your Social Security benefit exceeds the base amount for your filing status.

Medicare benefits: When you are disabled, you may be eligible to enroll in Medicare. If you pay premiums for the medical insurance portion of Medicare, you may deduct these premiums as a medical expense (provided, of course, that your medical expenses exceed 7.5 percent of your adjusted gross income). In addition, Medicare benefits you receive are not taxable.

Note: Starting in 2013, the threshold to deduct medical expenses will be raised from 7.5 percent of adjusted gross income to 10 percent. The threshold increase will be delayed until 2017 for those age 65 or older.

Workers' compensation: Generally, if you receive a disability benefit from workers' compensation, that benefit won't be taxable. Any benefits paid to your survivors would also be tax exempt. However, in certain cases, you may be able to return to work and continue to receive payments. If this is the case, then your workers' compensation benefit would be taxable. Note, though, that if part of your workers' compensation benefit offsets (reduces) your Social Security benefit, then that part is considered to be a Social Security benefit. It may then be taxable according to the rules governing Social Security.

Veterans benefits: Disability benefits you receive from the Department of Veterans Affairs, formerly known as the Veterans Administration, are not taxable, except for certain payments for rehabilitative services.

Military benefits: Most military disability pensions are taxable. However, if you were disabled due to injury or illness resulting from active service in the armed forces of any country, your disability benefits may be tax free under certain conditions.

Federal employees retirement system (FERS) benefits: If you retire on disability, the payments under FERS that you receive from a pension or annuity are taxable as wages until you reach minimum retirement age. Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension.

Is it wiser to buy disability coverage with pretax or after-tax dollars?

If you pay for disability income insurance with pretax dollars, you are (in effect) reducing your taxable income. This means that you won't have income taxes withheld on the portion of your income you used to pay your disability income insurance premium. However, you also have to consider how your benefit would be taxed if you ever begin receiving disability benefits. If you use pretax dollars to pay your insurance premium, then your benefit would be fully taxable. However, if you use after-tax dollars, your benefit won't be taxable.

It comes down to this: If you never use your disability benefits, you'll save money by paying your premiums with pretax dollars. But if you do use your disability benefits, using after-tax dollars to pay your premiums places you in a better position. Consult your tax professional for advice.

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