If you have recently been approved for long-term disability insurance (LTD) benefits, then your first instinct may be to breathe a sigh of relief. However, it is never too soon to begin evaluating the tax considerations long-term disability benefits may present in your situation. The taxability of long-term disability benefits depends primarily on how the policy premiums have been paid, but a variety of factors can serve to complicate this relationship between LTD payments and income tax. An accountant or experienced LTD benefits attorney may be able to help you evaluate the tax considerations for LTD income if you have specific questions about your own case.
Do You Have To Pay Taxes on Long-Term Disability Income?
If your long-term disability plan was a policy you purchased individually, and you paid the premiums out of your own post-tax income, then normally you will not owe income taxes on the benefit payments made under that policy. Most people who purchase long-term disability policies on their own, rather than gaining access to disability insurance through an employer’s group-sponsored plan, do pay their premiums in this manner.
Tax Considerations for LTD Income for Self-Employed Individuals
However, individuals who purchase long-term disability insurance because they are self-employed and know that becoming disabled will mean not just the loss of their personal income, as well as individuals in certain “pass-through” business tax structures, such as many partnership businesses, may pay their long-term disability insurance premiums with income that has not yet been taxed. These employment scenarios, which do not readily lend themselves to tax withholdings in the same way that work for an employer typically does, can substantially influence tax considerations for LTD income.
Tax Considerations: Long-Term Disability Benefits vs. Premiums
If your long-term disability insurance was a group plan benefit through the employer you worked for prior to becoming disabled, then the relationship between your LTD payments and income tax will be different. The taxability of long-term disability benefits is not actually determined by the group vs. individual policy distinction. Instead, the tax considerations long-term disability benefits present arise from how the policy’s premiums have been paid.
Most employer-sponsored plans pay the employer’s portion of the premium with before-tax dollars, and a majority of people paying premiums for policies they selected and paid for independently do so with wages that have already had state and federal income taxes withheld.
For these reasons it is a tendency, but not an absolute rule, for LTD benefit payments from a group plan policy to be considered taxable income, and for benefit payments for individually purchased LTD policies to be exempt from income taxes.
Tax Considerations for LTD Income: Shared Premiums
Because the real basis of tax considerations long-term disability benefits recipients may find most impactful is how the premiums have been paid over the life of the policy, any factors which have affected that payment history can also affect the relationship between LTD payments and income tax. If both you and your employer contributed to the cost of LTD premiums while you were employed, then Internal Revenue Service (IRS) rules specify that only the portion paid for by your employer will be taxable. However, the calculations you will need to perform in order to determine how much of your premium was covered by your employer, and then translate that information into a portion of your benefit on which you owe income tax, may sometimes be complicated.
Taxability of Long-Term Disability Benefits if Employer Reported Premiums as Compensation
The rule regarding LTD payments and income tax after premiums have been paid by employers is based partly on the assumption that those premiums will have been paid with before-tax dollars. If this assumption for any reason does not apply in a particular case, that can affect the tax considerations long-term disability benefits present.
The way employers report each employee’s compensation is also a major factor in this respect. IRS rules call for premiums paid on an employee’s behalf as part of a benefit plan to be reported as part of the employee’s gross compensation in most cases. If the value of the monthly or annual premiums is computed in an employee’s gross compensation on the individual’s annual W-2 form, then generally speaking that amount is considered part of the employee’s taxable income for the reporting year and taxes are paid at that time. If the employer does not compute the value of premiums as part of the employee’s total compensation, then the amount will not be included in the employee’s annual taxable income calculation, and any benefit payments he or she receives later will typically be subject to income taxes for the year in which the individual receives those payments.
Are Long-Term Disability Benefits Taxable Income?
Most of the time, long-term disability benefits are considered taxable income. This can be particularly likely with the employer-sponsored group plans that account for the majority of long-term disability insurance policies. The frequent taxability of long-term disability benefits under employer-sponsored plans is largely due to how group plan LTD premiums are typically paid. Federal LTD payments and income tax rules call for taxing long-term disability benefits when the premiums have been paid with pre-tax dollars. Pre-tax premium payments tend to be the norm when the payments are made and managed by employers, although some organizations diverge from the pack. A few offer employees the option of choosing whether they would prefer their premiums to be paid before vs. after taxes, a decision which can affect the employees’ net pay.
Many employers choose to offer long-term disability insurance in their employee benefit packages because these non-salary forms of compensation tend to be highly valued by employees and their families. However, the benefits provided under these group plans typically replace a somewhat lower percentage of a former employee’s pre-disability income than do many LTD policies sold directly to consumers on the open market. In combination with the tax considerations long-term disability benefits whose premiums employers have paid using pre-tax dollars, often disabled workers can often experience a steep drop in their available income, even after their long-term disability claims have been approved.
Do Taxes Get Taken Out Of Disability Payments?
Many employees are used to having income taxes withheld by their employers on each paycheck. Typically these tax withholdings will include both state and federal taxes, a consolidation which can simplify the employee’s calculations somewhat. An additional benefit, to some, is that when taxes withheld throughout the year exceed the employee’s total tax liability for the tax year, then the individual may receive an income tax refund after their taxes have been filed and processed, usually early in the following year. Many American families plan ahead for, and base their budgeting considerations on, those refunds.
Long-term disability insurance companies will not normally withhold taxes from LTD benefit payments in the same way that an employer withholds taxes from a check. However, you may be able to calculate your tax liability with IRS Form 1040-ES and make payments throughout the year using vouchers, in order to avoid a potentially hefty lump sum balance of taxes owed in April of the next year. These vouchers are often used by individuals who are self-employed, and for much the same reasons. However, the calculations for taxes owed on long-term disability benefit payments will differ from both self-employment tax and the taxes an employee pays on tips and wages, because both of these are examples of earned income taxes. Depending on the amounts earned, those forms of income may also be eligible for the earned income tax credit. Long-term disability benefits that are considered taxable because the policy premiums were paid with before-tax dollars are not normally treated as earned income, and the taxes on these benefit payments are assessed according to a separate set of rules.
Is LTD Considered Earned Income?
Long-term disability benefit payments are not usually considered a form of earned income for the year in which they are received. They may still be reportable and even taxable income for that tax year, but because they are not money received in exchange for the performance of any form of work, they will usually be reported as unearned income. Other examples of unearned income include lottery winnings and some large gifts.
The IRS follows a detailed set of rules in determining whether or not LTD benefits are taxable, but for individuals trying to gauge the relationship between LTD benefits and income tax, often focusing on the earned vs. unearned distinction can be something of a distraction. Most of the time, a more useful measure by which to understand the taxability of long-term disability insurance benefits is whether the LTD insurance premiums were paid initially with before-tax vs. after-tax dollars.
Long-Term Disability Tax Considerations
If you are wondering about the taxability of long-term disability benefits, the short answer is that the relationship between LTD payments and income tax is based primarily on whether the premiums were paid with before-tax dollars vs. after-tax dollars. Disability benefits received under a policy whose premiums were paid with after-tax dollars are usually not considered taxable income, while disability benefit payments received under a policy whose premiums were paid with before-tax dollars are generally considered income on which the recipient owes taxes. However, tax rules tend to be complex, and it is not unusual for individuals to have specific concerns about the tax considerations for LTD income in their own situations that are not widely addressed in materials aimed at the general public. A conversation with a disability attorney or an accounting professional may help you to gain a firming footing in the tax considerations long-term disability benefits present in your personal circumstances.
