Long-term disability insurance is a significant benefit that can protect employees with unexpected injury or illness that prevents them from working. Unfortunately, these benefits are not widely available. According to the Bureau of Labor Statistics, only 35 percent of civilian workers in the U.S. had access to long-term disability benefits in March 2020. Even if a worker does have this insurance coverage, they must face the potential tax implications of any benefit payments.
Whether long-term disability (LTD) benefits are taxable, tax-free, or tax-deductible depends on (1) who pays the premiums for the insurance policy and (2) whether you paid the premiums with pre-tax dollars or post-tax dollars. Let’s examine how this works by examining some of the most common scenarios for LTD premium payments.
Employer-Provided LTD Coverage
Employers sometimes offer LTD benefits to their employees at no cost to the employee. While it is not common for an employer to pay the entire premium, it occasionally happens.
The Hartford reports that any LTD benefit paid out from this policy will be taxable to the employee. This tax status results from the premiums serving the employer as a business expense. The employer paid no taxes on the premiums, so if the employee receives a benefit from the same policy, they must pay taxes on those funds.
The amount of tax they pay will depend on the employee’s income. LTD benefits replace an employee’s income, so they are income for tax purposes. Like other income, the amount of taxes due will depend on the tax bracket the employee falls under.
LTD Coverage Paid by an Employee
Employees can purchase their own LTD insurance policy and pay for the premiums themselves. To determine whether benefits from a policy are taxable, the IRS will look at whether anyone paid taxes on the premiums. Often an employee pays these premiums with after-tax income. In that case, the employee paid the taxes, and any benefits will not be taxable.
Premiums Paid with Pre-Tax Earnings
The employee can also pay their premiums from untaxed sources. If they pay them with pre-tax earnings or other untaxed assets, the employee will have to pay taxes out of any benefits paid under the policy. Employees who do not want these benefits to be taxed should work with a tax professional to ensure that they pay the premiums with funds that the IRS considers “post-tax.”
LTD Coverage Shared by Employers and Employees
In some cases, both the employee and the employer contribute to paying premiums for an LTD policy. If, for example, an employer withholds earnings from your paycheck to pay for part of the premium, the company might pay the rest of the premium as part of a benefits package. This scenario can result in an LTD benefit that is partially taxable.
The IRS will tax benefits from employer-paid premiums. (Again, no one paid taxes on this portion of the premium yet, so the employee must pay taxes out of any benefits received.) But the employee may not need to pay taxes on the portion they paid for. If the employee paid this premium from taxed earnings, they have already paid the required taxes and are entitled to benefits without being taxed on them.
An LTD plan can pay benefits on many different schedules. A claimant might receive weekly or monthly payments for a set time. In other cases, there might be a lump sum settlement for the total amount of benefits due under the policy. Recipients pay taxes on lump-sum settlements in the same way as any other LTD benefit.
If the purchaser pays the disability insurance premiums for the plan with taxed funds, the benefits are not taxable. The settlement benefits are taxable if they paid the premiums with untaxed funds (such as pre-tax earnings). The taxes on a large settlement can be staggering. Employees must also consider paying their premiums with after-tax dollars to avoid a burdensome tax bill on a lump sum settlement.
LTD vs. Social Security Disability Income (SSDI)
Understanding the difference between long-term disability (LTD) and Social Security Disability Insurance (SSDI) is essential. Both LTD and SSDI can replace lost income due to a disability. LTD is an optional coverage that employees and employers may purchase through private insurance companies. SSDI is a benefit available after a taxpayer earns the minimum number of work credits to qualify for Social Security benefits.
According to the Social Security Administration, the minimum number of work credits is currently forty, and taxpayers can earn up to four credits in a calendar year. Workers earn credits by paying Social Security FICA taxes. W-2 employees pay this tax through paycheck withholdings, while independent contractors pay a self-employment tax. Both taxes accrue Social Security credits for calculating SSDI eligibility.
So how are LTD and SSDI different for tax purposes? On LTD, the taxability of benefits will depend on who paid the policy premiums and how. For SSDI, the taxability of benefits depends on the recipient’s income. The IRS sets a base amount as a threshold for taxation. If the recipient’s adjusted gross income (AGI) plus half of their SSDI benefits combined is below the current base amount, their SSDI will not be taxable.
If AGI plus half of the SSDI is over the base amount, up to 50 percent of the SSDI can be taxable. And according to H&R Block, up to 85 percent of the SSDI benefits can be taxed in cases of higher income. These confusing thresholds can lead to many tax complications. Recipients might even face the stress of an audit over unclear tax rules for different disability insurance benefits. You can prevent these problems by working with tax professionals to develop a comprehensive financial strategy for disability benefits.
FAQs About Taxes on Disability Benefits
There is no question about it — taxes are confusing! Tax liabilities are also specific to an individual’s circumstances, so it is essential to get advice from a tax professional about your particular income. Here are some general answers to common questions about the taxation of LTD benefits:
Will I get a W-2 for disability income?
Depending on the policy, either an employer or the insurance carrier will issue a W-2. Even if the benefits are not taxable, give your tax preparer the W-2, so you can report the income reported properly on both state and federal tax returns. Your tax preparer will also use the W-2 to calculate your annual income accurately.
What if my LTD benefits come from a collective bargaining agreement?
Unions often negotiate employment agreements on behalf of a large group of workers. These agreements cover working conditions, wages, and employment benefits — including disability coverage. Whether a union negotiates group disability benefits or not, the taxation rules remain the same.
Premiums that an employer pays will result in the employee paying taxes on any benefits paid under the policy. If the employee pays the premiums, they may not have to pay taxes on the benefits, depending on whether the employee pays the premiums with earnings already taxed. Premiums that both an employer and an employee pay can result in partly taxed and partly tax-exempt benefits.
What about state and local taxes?
The rules described above apply to federal taxation of LTD benefits. There is always the possibility that state and local taxes will apply to any disability benefits, so be sure to understand the taxes owed before using benefits to pay other expenses. Different rules can apply depending on where the policy is issued, where the employment occurs, and where the employee resides. These state tax issues can be incredibly complicated when an employee lives in one state but works in another. Be sure to seek tax advice before the taxes come due on benefits you have already spent.
How are short-term disability benefits taxed?
Short-term disability benefits can also be taxed. The federal tax rule is the same for short-term and long-term disability benefits: if the purchaser pays the premiums with taxed funds, you do not pay taxes on the benefits. The benefits can be taxed if the employer or employee pays the premiums with untaxed funds (such as an employer’s benefits or an employee’s pre-tax earnings). Short-term disability benefits can also be partially taxed and partially not taxed in cases where the purchaser paid the premiums with a combination of taxed and untaxed funds.
If my funds are taxed, how much will I have to pay?
As with other income taxes, the percentage of taxes you pay depends on your total income. Those in higher income brackets must generally pay a higher percentage of taxes on their total income. Some tax brackets also impose progressively higher tax percentages on different portions of income. (For example, a set percent up to a set dollar amount, then a higher percentage of the income over that set dollar amount.)
These brackets confuse many taxpayers. It is best not to guess or make assumptions about the tax brackets the income falls under. Give a tax professional information about all your sources of income – including disability benefits – so they can prepare your tax returns accurately. This strategy can protect you from having to pay fines, back taxes, and interest for years to come.
Lump sums are also income. If a policy pays a one-time lump settlement or a lump sum as back pay for benefits owed, this income can quickly put the taxpayer in a higher tax bracket. It is also vital to prepare for the taxes you will owe on a large lump sum of benefits. If a disability policy offers the option of installment payments or a lump sum payment, consider the tax implications of a lump sum before choosing between these options.
What taxes will you pay on LTD benefits?
Disability benefits replace lost income. As a result, the taxes you paid on LTD (if any) are what you would have paid if you earned the income as an employee. The benefits are subject to federal income tax and the Federal Insurance Contribution Act (FICA). FICA collects a portion of earnings from both the employer and the employee to fund Medicare and Social Security. If your LTD is subject to taxes, you will pay both federal income tax and FICA contributions on the benefits.
Will my LTD payments deduct taxes?
If there is one piece of information to remember about LTD and taxes, it is this: a taxpayer is responsible for paying their taxes, whether they had taxes withheld or not. If an employee does not have enough tax withheld from their paycheck over the year, they remain responsible for paying the remainder to the IRS. Similarly, a claimant who gets LTD benefits is responsible for taxes owed to them, even if the insurance company did not withhold any taxes.
The law does not require insurance companies to withhold federal income tax from LTD payments. Employees can choose to implement voluntary withholdings if the insurance carrier offers this service. The employer or insurance company must report any withholdings for income tax to the IRS. You only owe FICA withholdings for the first six full calendar months of a disability. After that, the benefits are not subject to FICA, and the insurance company or employer should not make any more withholdings. Returning to work restarts the clock for these six months. In that case, the LTD benefits will again be subject to FICA withholdings, and the employee will also have FICA withholdings from their pay.
There is no doubt that taxes and LTD coverage can be confusing, so you should discuss these issues with a long-term disability attorney. A lawyer can help with every step of your LTD claim, including understanding tax obligations. If you have a disability, reach out today for assistance from a law firm that handles these claims. The right legal help can give you confidence as you seek your benefits.
Following graduation from Loyola Law School in New Orleans in 1990, Price McNamara served as a Federal Judicial Law Clerk to the Honorable John M Shaw, Chief Judge, United States District Court Western District of Louisiana.
Mr. McNamara founded J. Price McNamara ERISA Insurance Claim Attorney, and began putting his past experience to work for the injured and disabled clients he now represents against the insurance companies in personal injury and long term disability and other insurance disputes in both federal and state courts