Taxability of Disability Insurance Benefits: An Overview

Disability insurance replaces up to 60% of the policyholder’s pre-injury gross income. In exchange, the policyholder pays monthly premiums during the policy period. The amount of premiums paid depends on factors such as age, gender, income, health history, and the amount and type of coverage. In case of a disability, the policyholder will receive disability benefits in the form of monthly paychecks. Depending on how they’re classified for tax purposes, these benefits may or may not be taxable. In general, individually purchased policies pay tax-exempt benefits, whereas benefits received from employer-sponsored plans are taxable. Here is more detailed information on this topic.

Tax-Free Disability Insurance Benefits

You owe no taxes if you have an individually purchased plan and are not part of an employer-funded plan. On the other hand, if you are part of an employer-sponsored plan, your benefits are subject to tax. The reasoning here is employer-sponsored plans are purchased with pre-tax dollars, whereas individual plans are purchased with post-tax dollars. In certain cases, the policyholder can pay a portion of employer-funded disability insurance premiums using after-tax dollars, making some of the benefits nontaxable.

Employer-Sponsored Disability Insurance

About 35% of American workers in the private industry have some form of employer-funded disability insurance coverage. The federal government also provides disability insurance coverage to its workers through programs such as Supplemental Security Insurance and Social Security Disability Insurance. Employer-funded disability policies are generally more affordable since they come with either partial or complete subsidies. Additionally, they are easier to get considering insurance companies don’t conduct individual underwriting to assess risks at a personal level.

The downside of employer-sponsored disability insurance is that the benefits are generally taxable, mainly because most employers pay for their employees’ disability insurance premiums using pre-taxed income. Therefore, if you have an employer-funded disability insurance policy, your benefits will likely be taxable. Even so, there are exceptions in which employer-sponsored disability benefits may only be partially taxable. They depend on the following factors:

  • Amount of premiums paid using pre-tax income – Some employers only pay a certain portion of their employees’ disability insurance premiums using pre-taxed income. In such a case, the disability insurance benefits will be partially taxable. The amount of taxable benefits will depend on the amount of disability insurance premiums paid using untaxed income. For instance, if the employer pays for 60% of the premiums using pre-tax dollars, only 60% of your disability insurance benefits will be taxable. This kind of arrangement is usually common in employer-funded supplemental disability insurance policies.
  • Amount of premiums paid using after-tax income – If you pay the whole of your premiums using already taxed income, your benefits will not be eligible for taxation. Also, if you only pay a small portion of the premiums using after-tax dollars, the federal government will tax the benefits depending on the balance left.

Reporting Disability Insurance Benefits

For taxation purposes, the IRS classifies disability benefits received through the employer’s disability plan as “sick pay,” meaning the benefits are part of your taxable income. Therefore, if you’re eligible for “sick pay,” you have to fill out and submit IRS Form W-4S to your employer’s insurance company. Alternatively, you can report your estimated tax payments directly to the IRS using Form 1040-ES.

How Kneller Insurance Agency Can Help

Some disability benefits are taxable while others are not. It all depends on the type of disability insurance policy you have. Contact our experts at Kneller Insurance Agency for more information on getting the right disability insurance coverage for your needs at rates you can afford.

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