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Columns: Tax Talk
George Saenz, CPA   Expert: George Saenz, CPA
Tax Talk
What portion of disability benefits are taxable?
Tax Talk

Disability insurance premiums

Dear Tax Talk,
I will soon be receiving two and a half years of back pay from disability insurance and I am confused about how much or what part I must pay taxes on. My employer paid the premiums for basic long-term disability and I paid for "enhanced" long-term disability with after-tax dollars, which shortened the waiting period from 180 days to 90 days. Does this mean that the only portion that is nontaxable is the amount of the back pay that is equal to 90 days of pay, and the rest, including future monthly payments, is taxable?
-- L

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Dear L,
In a recent article, I discussed the income tax implications of employer- versus employee-paid disability insurance premiums. Basically, if you pay disability premiums personally, any benefits you receive are excludable from income.

If your employer pays the premiums, the benefits received under the policy are taxable. Employers who are cognizant of these tax consequences are allowing employees to choose to have the premiums included in their wages and avoid income taxes, should they have to collect under the policy. Because most policies pay between 60 percent to 65 percent of your salary, receiving the benefits tax-free when coupled with Social Security Disability Income almost make the employee whole.

Typically, if an employer and employee contribute to the disability insurance, the taxation depends on the relative contributions. However, in your case, you have two distinct insurance plans, so the relative contributions are not applicable.

IRS Revenue Ruling 2004-55 clarifies the IRS position when premiums are paid by an employer or employee or a combination of both. The ruling provides the following:

Finally, the applicable statutes and regulations do not distinguish between short-term and long-term disability plans. Thus, if an employer offers both short-term and long-term disability plans and permits employees to separately elect the contribution payment method for each plan, the law does not require aggregation of the contributions paid for each plan in determining the taxation of benefits. Benefits paid under a short-term or long-term disability plan will be taxed according to the contribution payment election made for each type of coverage.

Because you chose to pay for the 90-day policy on an after-tax basis only, that part of your benefits will be exempt. Because your employer paid for the long-term coverage and excluded the premiums from your wages, the remainder of your settlement and future payments will be taxable. However, since the stakes are high, I suggest you get advice from an accountant or attorney who can familiarize himself better with your particular circumstances.

Bankrate.com's corrections policy -- Posted: July 15, 2008
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