Under what conditions are group disability income benefits received by an employee not taxable?

As disability attorneys, we cannot emphasize enough the problems disability insurance taxation can cause if you’re not prepared. Many claimants come to us who unfortunately have been caught by surprise when the IRS taxed their benefits.

If you receive disability insurance benefits, you need to know whether the IRS says those LTD benefits are taxable or not. The answer is based on who paid the premiums for the coverage, and the pre-tax or post-tax status of the premium payments.

Most people don’t realize how different the laws are that govern group disability insurance and individual disability policies, in terms of costs, benefits, taxation, and claim disputes.

While tax advice always comes from your tax accountant, the team at Marc Whitehead & Associates can provide insights as to how different forms of long-term disability insurance are taxed under different circumstances. 

And, while IRS rules do not technically affect disability claim adjudication, disability insurance companies are keenly aware of disability insurance taxation issues, and may even resort to strategies that benefit their bottom line. We protect our clients by ensuring their claims are handled fairly.

So for a few minutes let’s talk taxes. This post summarizes need-to-know facts about your LTD benefits and the taxes you may or may not have to pay once you draw those benefits. 

A Quick Review of Long Term Disability (LTD) Coverage

• Employer-sponsored group long-term disability plans. Group benefits cover all eligible employees and the employer typically pays all or part of the premiums as an employee benefit. This is the most common form of group LTD plan.
• Individual disability insurance (IDI) policies. This is private coverage that a person purchases through an insurance agent. IDI is more efficient and costly because each policyholder is individually underwritten. The policyholder may buy additional coverage (riders) to ensure maximum coverage regarding his or her profession and income replacement goals.
• Professional associations may offer group disability insurance plans. Examples are AMA and ADA-sponsored policies available to physicians and dentists. 
• You may opt for combined coverage, such as supplementing a group disability plan with an IDI policy.

The “Rule of Thumb” for Disability Insurance Taxation

Every plan or policy for disability insurance has premiums that someone must pay. Those payments will come from either pre-tax dollars or post-tax (after-tax) dollars. 

• Pre-tax dollars mean income where no deductions of federal, state, and withholding taxes have occurred. 
• Post-tax dollars signify income after federal, state, and withholding taxes have been deducted.

Generally:

• If premiums are paid with pre-tax dollars, your disability insurance benefits are taxable to you. In this case, you would include the amount of benefits you receive on your tax return as part of your salary or wages.
• If disability insurance premiums are paid with post-tax dollars, your LTD benefits are not taxable. You would not pay taxes on the disability benefits you received. 

One way or another, the IRS gets its tax money — either as taxes paid on money used to pay premiums or on taxes paid on disability benefits received. 

Let’s take a look at several common scenarios.

Are LTD Benefits Taxable under a Group Disability Plan?

Typically yes, group disability benefits are taxable. Employer-paid premiums in a group disability insurance plan is a tax deduction for the employer as a business expense. 

In most cases, LTD premiums are paid by the employer on a pre-tax basis and are not reported on the employee’s Form W-2 for that year. The employer would not include the cost of the disability insurance coverage in the employee’s gross income; therefore, the employee would report received benefit payments as income on his or her tax return. 

The scenario above is the most common for group LTD plans. However, other forms of LTD benefit payments are offered by various insurance carriers, resulting in varying tax consequences. 

Again, the determining taxation factors are “who” pays for LTD premiums (employer, employee, or shared) and whether premiums are paid with pre-tax or post-tax dollars. If group LTD plans are paid with after-tax dollars, then benefits received are not taxed. 

Below are common examples:

How Pre-Tax vs. Post-Tax Premium Payments Cause Different Disability Insurance Taxation

1. Your employer pays 100% of the group disability insurance premium and deducts the premium as a business expense. The benefits you receive will be considered taxable income (100% taxable to you.) 
2. Some employers offer “cafeteria plans” where an employee selects among certain employee benefits like health, life, and disability insurance. Employees usually pay for these benefits on a pre-tax basis (through payroll deduction). Some employers may contribute to the premiums up to a certain amount, and the employee pays for extra coverage they choose with either pretax or after-tax dollars.

Examples:

• Your employer may offer a post-tax premium payment plan that you can opt into:  
  • If you and your employer share contributions to the disability premiums (you pay a portion with after-tax dollars and the employer pays the balance) you will only pay income tax on the percentage of the benefit amount you receive that was paid by your employer.
  • If you pay 100% of the premiums with post-tax dollars, your benefits are 100% tax-free when you receive them. Any premiums paid in this manner are not taxed.
• Your employer may offer a pre-tax premium payment plan that you can opt into:  

• If you and your employer share pre-tax contributions of the premiums, 100% of the taxes will be payable by you.
• If you pay 100% of the premiums with pre-tax dollars, 100% of the taxes will be payable by you.

The above examples explain different options available in group disability insurance plans. Many details come into play for your tax advisor to help you navigate in your specific situation.

Beware the 60% LTD Plan Shortfall: Benefits Are Further Reduced by SSDI and Taxes.

The amount of group LTD coverage may vary from plan to plan, company to company. Most group LTD plans only insure up to 60% of your base salary, with no protection for bonus income.  

Why is this important? The taxability and offsets that plague employer-paid LTD benefits cause the take-home benefit amount to be much less than expected. Wherever you fall in the income spectrum, you are likely unaware of just how under-insured you may be. 

When disability strikes and benefits are paid, the replacement income you thought you would get stands to be reduced three more times:

1. SSDI Offset: You may receive LTD and SSDI benefits at the same time. 60% group disability plans are set up (actually written into the Plan) to allow the insurance company to offset your Social Security disability insurance (SSDI) payments. This means your insurer will deduct the amount Social Security pays to you in benefits from the checks they send to you. (Various other offset clauses may be in the policy language as well.)

We advise our clients how SSDI will impact their LTD benefits, and whether the insurance company will offset any payment of SSDI (and other offsetable benefits) that they may be entitled to.

1. Taxability: LTD benefits are further reduced in group disability plans because you pay taxes on those benefits when you receive them. 
2. Inflation: Most group LTD benefits are not indexed for inflation, meaning the initial amount of the benefit will remain the same throughout the life of your claim.

Meanwhile, the employer who paid your premiums is taking a tax deduction on those premiums as a business expense. And the insurance company takes a hefty Social Security Disability back pay.

Example: 

• If you are a dental assistant making $39,000 a year, and your group disability pays 60% of your income, you would assume you’ll receive about $23,400 a year in benefits or $1950 in monthly benefits. 
• But you also filed for SSDI and those monthly payments are $1000. The insurance company gets to offset that amount from the 60% originally stated, which brings your LTD benefit payment down to $950 a month. 
• Then you pay taxes. Your employer paid 100% of the premiums, so you owe 100% of the taxes. Inflation plays its part, and what appeared to be an annual benefit of $23,400 now falls to under $10,000 a year in benefits.

In the case of a disabled CEO, surgeon, or other highly compensated professional covered by employer-paid LTD, the margins increase drastically. The taxability of the benefit causes a huge reduction in actual benefits received. 

The insured in a 32% tax bracket who becomes disabled suffers a tremendous shortfall. Even though most group LTD plans put a cap on highly compensated employees, the disability insurance taxation issue alone can cause a major deficit in actual benefits. 

Private Disability Policies – Are Individual Disability Benefits Taxable?

Disability benefits received from an individual disability policy you bought personally, with post-tax dollars, are not taxable.

However, the choice of paying for an individual policy with pre-tax vs. post-tax dollars is up to the policyholder. Using after-tax money is the preferred method, as you pay more now but have maximum funds available should you become disabled. If long-term disability becomes the reality, all taxes will have been paid.

If your premiums are paid with pre-tax dollars, you would need to pay taxes on your long-term disability benefits.  

Disability Insurance Taxation on a Lump Sum Buyout

Your insurer may come to you with a lump-sum buyout offer. This is a one-time fixed payment where the insurance carriers want to pay you a percentage of the remaining value of your claim. The lump-sum payment puts an end to the continuing monthly payments.

Again, disability insurance taxation comes down to whether premiums were paid with pre-tax or after-tax dollars. If your lump-sum buyout is taxable, be aware that the one-time payment the insurer offers may be substantially reduced by taxes.

Business Structures and Disability Insurance Taxation

A business’s legal structure influences the taxation of any disability benefits received by the business owner or other employees. Most businesses that provide long-term disability insurance coverage to employees as a group benefit will treat the purchase of premiums for the LTD coverage as a tax-deductible expense. Below are general guidelines about how disability insurance taxes work under common business structures.

Sole Proprietorship – Benefits Are Non-Taxable

Many of our clients are business and medical professionals working as sole proprietorships, where the owner and business are the same. Disability insurance benefits would be purchased by the sole proprietor as an individual disability policy using post-tax dollars. These benefits, when paid to the sole proprietor, would not have any taxes due.

Corporations – LTD Benefits Are Usually Taxable

In a “C” corporation, owners who receive wages and receive W2’s are technically employees. The corporation may pay premiums for disability coverage for employees and use this as a tax-deductible expense. When the corporation pays the entire premium, the LTD benefits are taxable to the employees, including the owners.

Partnerships – LTD Benefits Can Be Taxable or Nontaxable 

In partnerships, the IRS does not consider owners to be employees. The cost of insurance for the owners is included in their gross income. Disability benefits are nontaxable to the partners/owners receiving them. 

A partnership may treat LTD premiums for employees as a tax-deductible expense. When the partnership pays the premium for employees, disability benefits are taxable to the employees.

Note: For tax purposes, the IRS treats S Corporations and limited liability companies as partnerships.

Key Person Disability Plans – Tax-Free to the Recipient 

A “key-person” policy is paid for and owned by the business. An employer takes out a disability policy for a preset period on behalf of one or several irreplaceable employees—individuals who are considered to be “key persons” in the company’s operations. The business figures that it would suffer significant setbacks if its most valuable individual(s) cannot work due to a disabling condition. 

A company needs this compensation to cover staffing costs, project delays, profit loss, and maintain financial stability in the eyes of stakeholders. The employer pays the premium, which is not deductible, and benefits paid to the business are tax-free.

IRS Tax Reporting Guidelines for Disability Benefits 

The IRS website is not the easiest to navigate. The following links are to current IRS publications regarding disability insurance taxation.

Tip: The IRS classifies both short-term disability and long-term disability insurance benefits as “sick pay.” IRS home page:  https://www.irs.gov

And specifically regarding disability insurance taxation: 

• FAQ: Is the long term disability I am receiving considered taxable? 
• Publication 907 (2020), Tax Highlights for Persons With Disabilities 
• Publication 15 (2021), (Circular E), Employer’s Tax Guide 
• Publication 15-A (2021), Employer’s Supplemental Tax Guide

Questions about your Disability Claim? Contact Marc Whitehead & Associates

With taxes, surprises are seldom good. No disability claimant should end up underinsured because taxes and offsets are unexpected or poorly handled. 

At Marc Whitehead & Associates, our experienced legal team can make sure there are no surprises. While we do not offer tax advice to our clients, we can help ensure that you are aware of all disability insurance taxation issues to discuss with your tax advisor. And you will know your disability claim is being handled properly. Contact us or call 800-562-9830 for a free legal consultation to learn how we can help you with your disability insurance claim.