Are Disability Insurance Benefits Taxable? I Hope So

by Neal Frankle, CFP ®

If you receive disability benefits, the last thing you want to do is run afoul of the IRS. So it’s important to have the right answer to this question. But before you ask, “Are disability insurance benefits taxable?” maybe you should be sure of the pros and cons. Don’t be so sure you want tax-free benefits. (Of course, the first question is, do you need a disability insurance policy at all, but I’ll assume you’ve already answered that question.)

So let’s take a look at the main question about taxation of disability benefits. The answer depends on who paid for the insurance and how they were paid. Specifically, if the disability insurance premium was paid for with before-tax dollars, the benefits are taxable and must be included in your tax return. If the premiums were paid with after-tax dollars, the benefits are tax-free.

If your employer paid the premiums and didn’t include those premiums as a taxable benefit (not included in your gross income), that means the payments were pre-tax. And that means the benefits are taxable to you. Happy Day. So if you want to make sure the potential benefits are tax-free, make sure the premiums are taxable. (But we’ll see in a minute that this may NOT be the way to go.)

If you are talking about disability insurance for self-employed people, it is a special question. If you are a small business owner or freelancer and have your own disability insurance, you may pay for that policy as a business expense. That’s fine. But if you don’t include it in the employees’ gross income, the benefits are fully taxable to the recipient.

If you are said recipient and (heaven forbid) become disabled and start collecting disability insurance benefits, make sure to speak with your tax preparer immediately. You should set up quarterly tax payments. This way, you won’t find yourself in a bind when it comes time to file your return.

Now, another smart question comes up…and that is…do you really want those benefits to be tax-free? I’m not sure about the answer. If you know you’re about to collect, maybe the answer is yes.

But most of us have no idea if and when we’re really going to need to collect those disability benefits. And the fact is most of us never do collect disability insurance benefits. As a result, you have a choice between getting a tax write-off now or not. If you take the write-off, you will have to pay taxes on the benefits, but it’s by no means certain that you’ll ever have a claim. At the same time, it’s absolutely certain that a tax write-off is a big benefit.

So, given the choice, maybe you don’t want those premiums included in your taxable income. It’s the age-old issue of the bird in the hand versus two in the bush.

Have you ever received disability insurance benefits? Did you pay tax on the benefits? Did you set aside money to pay the tax? If not, how did you handle your income tax liability? If you own a disability policy, are you paying taxes on the premiums in order to get tax-free benefits? Why or why not?

 

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{ 2 comments… read them below or add one }

Ethan August 15, 2011 at 7:23 PM

Seeing as most disability insurance is capped at 60% of pre-disability income, I don’t see how you have any room left to reduce that. I suppose if you really think you only need to insure 50% or even less of your pre-disability income, then taking the tax benefit now is a method by which you will be “paid” to take that benefit reduction. But for lower-premium products like group disability through an employer this would be a ridiculously bad deal. My group long-term disability policy through my employer (60%, 180-day elim) carries a monthly premium of about $14. I’m going to put 5-10% of the benefit at risk to save a couple of bucks a month? Even if I were paying an individual policy, which would cost about $110 for me, why would I want to save $10-15 a month but put hundreds a month at risk at the time I need it most? I don’t get it.

Reply

Neal Frankle August 15, 2011 at 8:42 PM

Ethan, you do make good points but it’s all a question of odds. And the odds are that you won’t have a claim. And, if you do have a taxable benefit, odds are the income w/be low so the tax won’t be terrible.

This does come down to a question of comfort and choice.

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