How Are Disability Benefits Taxed?

If you receive benefits from disability, how do you know if they are taxable or not? The central underlying principle to keep in mind is this: If you got a tax deduction for the premiums, or if someone else paid the premiums for you, benefits are taxable. If you paid the premiums yourself with after tax dollars, the benefits are generally tax-free.

Here is a look at some common circumstances to see how it works in practice.

Beneficiaries of a workplace disability plan

In this case, the employer generally pays the premiums and takes a tax deduction for it as an employee benefit. It's a cost of doing business. If the employee pays no premium, then any income benefits paid to the employee are subject to ordinary income tax.

If the employee paid half the premium and the employer paid the other half, then income to the beneficiary is 50 percent taxable - depending on how long the arrangement has been in place prior to the claim. The IRS requires you to calculate the beneficiary's premium contribution as an average going back three years.

Individuals buying private disability insurance

When an individual simply buys a disability insurance policy on the open market, premiums are not normally tax-deductible. It's a personal expense and therefore you pay premiums with after-tax dollars. But benefits paid to you are tax-free.

Corporation owner/employees

If you own a C corporation, you may be able to have the company buy the plan and take a tax deduction at the corporate level. If you do this, you will have a lower corporate tax bill, thanks to the deduction on premium as an employee benefit. But if the corporation paid 100 percent of the premiums, any benefits paid to you, personally, will be taxable.

Cafeteria plans

Disability insurance is a popular option for cafeteria plans -- also called "Section 125" plans for the part of the tax code that authorizes them. If the employer pays part of the premium and the employee also contributes, but on a pre-tax basis, then benefits are taxable to the employee. No tax was paid on premium dollars, so the tax must be paid on benefits.

Sole proprietorships and partnerships

Sole proprietors can go either way: If you are a sole proprietor you can treat the premiums as a business expense by including the premiums as a Schedule C deduction. If you do, benefits are taxable. You can also treat them as a personal expense and pay the premiums with after tax dollars -- simply by leaving them off your Schedule C. If you do, then benefits will be tax-free.

In the case of partnerships, premiums paid to cover non-owner employees are deductible. However, premiums paid to cover owners are usually taxed as compensation, and counted as gross income on the partners' personal returns. Premiums are not deductible, but benefits are tax-free.

Workers' Compensation

Benefits from Workers' Compensation insurance that is mandated by state law are usually tax-free. However, railroad sick pay received under the Railroad Unemployment Insurance Act is usually taxable except for job-related injuries.

For a more complete discussion of whether and how unemployment compensation is taxable and under what circumstances, visit IRS Publication 525 - Taxable and Non-Taxable Income.

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