Disability insurance provides essential financial protection by replacing a portion of your income if an injury or illness prevents you from working. It’s usually offered in two varieties. Short-term disability (STD) insurance pays benefits for a limited time, typically up to six months. Long-term disability (LTD) insurance pays benefits for an extended period, typically until you recover or reach retirement age.
While these products can be purchased individually, they are often offered through employer-sponsored benefits plans. And when offered through your employer, it’s important to know that the benefits you receive may be considered taxable income. Here’s what to know so you can avoid surprises at tax time.
What factors determine the taxability of disability benefits?
Whether benefits are taxable or not depends on how the insurance premiums are paid. Here’s how different payment arrangements affect taxation:
- Employer-paid premiums: If your employer covers the full cost of your disability insurance and doesn’t include the premium amount in your taxable income,1 any benefits you receive are taxable as income.
- Employee-paid premiums with pretax dollars: If you pay premiums via payroll deduction on a pretax basis, benefits received are generally taxable.
- Employee-paid premiums with after-tax dollars: If you pay the premiums with after-tax dollars, benefits received are typically not taxable. This is because taxes have already been applied to the money used to pay the premiums.
If a benefit is considered taxable, its value must be included in your gross income2 and reported to the IRS, potentially increasing your tax liability.
Examples: How benefits are taxed based on premium payment
These examples are for illustrative purposes only and are meant to provide a general overview of how coverage works. Any resemblance to actual persons is purely coincidental. Consult a tax professional or your benefits administrator for more information.
Meet John, a store manager. Here’s how John’s disability benefits would be taxed depending on how his premiums were paid:
- Employer-paid premiums: John’s company pays for his long-term disability insurance without including the cost in his taxable income. When John received benefits after a serious injury, the payments were taxable because the premiums had been fully employer-funded.
- Pretax premium deductions: John’s short-term disability premiums are deducted pretax from his paycheck. When he needed benefits after a temporary illness, the payments were also taxable.
- After-tax premium payments: John independently purchased supplemental disability insurance and paid premiums using after-tax dollars. When he received benefits, they were not taxable.
Key takeaways
Understanding how your disability insurance premiums are paid can help you anticipate the tax implications of any disability benefits you might receive. Contact your HR representative or a tax professional to learn more.
This is a high-level overview of the taxation of disability benefits. Insurance carriers are not responsible for determining taxability of their benefits. For specific information please consult a tax professional and/or your benefits representative.
Additional reading:
Short-term and long-term disability insurance: Financial protection when you need it most
