03 May Disability Benefit Taxes
Are My Disability Insurance Benefits Taxed?
Disability coverage is a crucial component of many people’s insurance portfolios, as this coverage protects you from the possibility of income loss due to a long-term or short-term injury or disability. While there are some variables regarding coverage amounts, disability insurance usually pays out roughly 60% of the income you brought in while working each month.
Because disability insurance benefits replace a portion of your employment income, it’s understandable if you have some questions regarding the way the Internal Revenue Service (IRS) handles these benefits. Do you need to pay taxes on them, just like you would with your salary from a job? Or are these benefits excluded from taxation?
As you’ll discover, the answers to these questions depend on how you originally purchased your disability insurance policy. In short, sometimes disability insurance payouts are subject to taxation, but other times, they aren’t. Let’s discuss why this differential exists and determine whether the IRS will require you to pay taxes on your disability benefits or not.
What Is Disability Insurance?
One of the most important aspects of anyone’s life in modern society is their ability to earn a living and support themselves. However, if you suffer a significant injury or illness that keeps you out of action for an extended period, you might be unable to provide for yourself. That’s where disability insurance comes in.
This form of coverage provides financial benefits to make up for a portion of your lost income. The variable aspects of disability insurance include how much your premium payments cost, which types of disabilities it covers, the financial value of your benefits (or how much income it replaces), and the duration of your benefits.
There are two main types of disability insurance: short-term and long-term. These two types of insurance are quite straightforward, as these terms both mean exactly what you think they do. Short-term disability coverage provides financial support if you’re unable to work due to a temporary injury or illness. Meanwhile, long-term insurance covers degenerative or otherwise debilitating conditions from which you may never recover.
What Disabilities Are Covered?
While the term “disability insurance” often leads people to assume it’s intended for serious physical injuries, this is actually a common misconception. In fact, the vast majority of disability insurance claims are due to illnesses or chronic medical conditions, not injuries. Of course, there are still plenty of instances where disability coverage comes in handy if you break your leg or suffer a concussion. Still, for the most part, the most common uses for disability insurance are arthritis, stroke, heart disease, back pain, depression, cancer, and diabetes.
The specific disabilities covered by each insurance plan do tend to vary, so you’ll need to make sure you understand the coverages and limits of your policy before you purchase it.
Individual vs. Group Disability Insurance
Disability insurance policies are available in either individual or group coverages. You can buy an individual policy at any time from your independent insurance agent, just like you would purchase renters insurance or auto coverage. On the other hand, you may be eligible for a group disability insurance policy from your employer or through an organization you’re involved with.
Some employers provide group disability coverage to their employees as part of their benefits package. In these circumstances, the employer will pay for some of the premium (in certain situations, they’ll cover all of it). The best part of group coverage is that the insurer cannot deny you coverage. However, the downside is that you will lose your coverage if you leave the company.
As you’ll see shortly, there’s a big difference in taxation depending on whether you purchase your own disability coverage or receive it from your employer.
Which Disability Insurance Benefits Are Taxed and Why?
If you pay for your disability insurance coverage using money that was already taxed, you will not need to pay any taxes on the policy’s benefits. Therefore, if you buy a disability policy using money from your regular paycheck — from which taxes have already been taken out — then you don’t need to worry about paying taxes on your benefits. After all, there’s no sense in paying taxes on the same money twice, is there? The entire point of disability insurance is to provide income if you lose your ability to work, but that doesn’t mean it’s taxed the same way as the money you earn from your job.
If you receive your disability insurance coverage from your employer, it’s a bit of a different story. Because these plans are typically purchased at least in part by the company you work for, there is a portion of the policy purchased with pre-tax money. In other words, if your employer pays your entire disability premium, you will need to pay taxes on all benefits. Even if they only pay for part of it, you will owe proportionate taxes on that amount.
Let’s illustrate this concept with a quick example. Assume that your employer pays for 65% of your disability benefits and that you typically make $1,000 per week. At some point, you develop a debilitating condition that leaves you unable to work. If your disability coverage provides 60% of your pre-disability income, that means the insurance company will give you $600 per week.
Of that $600, 35% is untaxed because you paid for 35% of the premium using your own after-tax money. However, the 65% that your employer paid for does require taxation. Therefore, you will need to pay income taxes on $390 of each $600 the insurance company pays out.
How to Report Disability Insurance Benefit Taxation on Your Return
Another issue many people run into is how you’re supposed to claim disability benefits on your annual taxes. For the taxable portion of an employer-provided disability insurance payout, the IRS will classify the benefits as sick pay. This means that you’ll need to take a few important steps to ensure that you remain compliant with all relevant tax laws and regulations.
First, you will need to do one of two things. You can fill out Form W-4S from the IRS, which is the “Request for Federal Income Tax Withholding From Sick Pay” document. This form requires your adjusted gross income, the estimated total of your itemized deductions, your annual tax responsibility, the estimated amount of federal income tax withheld from other sources, and the number of sick pay payments you receive per year. You will then provide this form to your insurance carrier, and they will withhold any relevant income taxes from your payouts.
The other option is to file a Form 1040 each year. This is the “U.S. Individual Income Tax Return” document — the same form used by self-employed persons and freelancers. With this option, you will need to make regular estimated tax payments to the IRS throughout the year. For the most part, the due dates are quite similar from year to year, although there are sometimes adjustments made to account for holidays and weekends. For 2021, these are the estimated tax payment dates:
- 1st Quarter: April 15, 2021
- 2nd Quarter: June 15, 2021
- 3rd Quarter: September 15, 2021
- 4th Quarter: January 15, 2022
It may seem unusual to have a second “quarter” that encompasses just two months, with a fourth “quarter” that includes four months, but this is how the IRS estimated tax system has worked for years.
Estimated taxes are quite simple, as you just need to pay the IRS for the amount of taxable benefit money you received in that quarter. You should make sure to provide them with sufficient funds because if you don’t, you’ll need to make up the difference between what you paid and what you owed by April 15 of the following year. Otherwise, you might be subject to some stiff penalties.
The amount of tax you need to pay for your disability benefits is the exact same figure as your personal federal income tax rate. Here are the current 2021 income tax rates for single filers based on annual taxable income:
- 10%: $0-9,950
- 12%: $9,951-40,525
- 22%: $40,526-86,375
- 24%: $86,376-164,925
- 32%: $164,926-209,425
- 35%: $209,426-523,600
- 37%: $523,601+
And here are the rates for married couples who file jointly:
- 10%: $0-19,900
- 12%: $19,901-81,050
- 22%: $81,051-172,750
- 24%: $172,751-329,850
- 32%: $329,851-418,850
- 35%: $418,851-628,300
- 37%: $628,301+
Keep in mind that if you live in a state with state-level income taxes, you will also need to pay those taxes on your pre-tax disability insurance benefits. Your state may have its own requirements for taxation on sick leave pay, so don’t assume the same federal-level rules apply.
Are Social Security Disability Benefits Taxed?
In addition to the option of purchasing privately-funded disability coverage from an insurance company, the Social Security Administration has a disability insurance program. The Social Security Disability Insurance program is a federal fund that’s paid for by tax income. These benefits are typically much harder to get than payouts from your private disability insurance because the requirements are strict.
To receive benefits from the Social Security Disability Insurance program, you must have a physical or mental impairment that can be medically diagnosed. In addition, that disability must prevent you from providing yourself “any substantial gainful activity” through employment. Furthermore, the impairment must be expected to eventually cause your death, and it must last for at least one full year. On average, less than one-third of all people who apply for Social Security Disability Insurance benefits actually end up receiving payments, and the typical monthly payout is roughly $1,200.
So, what if you do qualify? Do you have to pay taxes on Social Security Disability Insurance benefits? Thankfully, the answer is no. No matter how much money you receive from the Social Security Disability Insurance program, you will never owe a dime in taxes on these funds.
It’s a similar story for the Supplemental Security Income program, which is also operated by the Social Security Administration. This is only an option for disabled people who are at least 65 years old and don’t have additional income. However, if you receive benefits, you will not need to pay taxes on them.
A small handful of states even have their own disability programs. If you live in California, Hawaii, New Jersey, New York, or Rhode Island, you may have access to a state-run disability insurance pool. All of these programs have their own eligibility guidelines and payment structures. Still, if you qualify, you will most likely be exempt from paying taxes on these benefits. For more information on these programs, contact your relevant state agency, such as the New York State Insurance Fund. They can provide you with all of the details to determine if you qualify for coverage or not.
Disability insurance is vital coverage for many Americans. After all, if you lose your ability to work, you need to find an alternative income source, which isn’t easy if you can’t earn traditional wages as an employee. Between self-funded disability insurance policies, those purchased by employers, and assistance provided by the federal government, there are several different ways to get disability benefits. And if you’re lucky enough to live in one of the five states that have their own disability insurance programs, you have even more options.
If your benefits were provided by the government, or if you bought an insurance policy using your own after-tax money, you will not owe a penny in taxes for your disability benefits. However, if your employer purchased your disability insurance (either in part or in full), you do need to pay taxes on the portion paid for by your employer.
Disability insurance coverage can be a complex topic with plenty of nuances. If you have any remaining questions, you should direct them to your independent insurance agent. They can help you figure out which type of coverage you need, how much coverage you should buy, and how taxation applies to this insurance purchase.