How are disability payments taxed?
The first step into determining how the disability income is taxed is to look into who paid the benefit. For example, if the income is paid directly to you by your employer, it is taxable to you just as your ordinary salary would be. In addition, taxable benefits are also subject to federal income tax withholding, although, depending on the employer’s disability plan, in some cases they are not subject to the Social Security (FICA) tax.
Tax Treatment of Disability Payments
The more common case, however, is that the payments are not made by the employer but by an insurance company under a policy providing disability coverage or, under a similar legal arrangement having the effect of accident or health insurance.
IRS Tax on Disability Payments
Next, the IRS will look at who paid for the coverage that entitles the injured person to receive the benefits. If your employer paid for it, then the income is taxed to you just as if paid directly to you by the employer. On the other hand, if it’s a policy you paid for, the payments you receive under it are not taxable.
Even if your employer arranges for the coverage, the benefits are not taxed to you if you (and not your employer) pay the premiums. This could mean that an amount is deducted from each pay check to pay for the coverage. For these purposes, if the premiums are paid by the employer but the amount paid is included as part of your taxable income from work, the premiums will be treated as paid by you.
Benefits Paid to You
Special rules: In the case of a permanent loss of a part of the body, or a permanent disfigurement, employer disability payments are not taxed, as long as they are not computed based on amount of time lost from work. This is the rarest case usually.
Social Security disability benefits: This discussion doesn’t cover the tax treatment of Social Security disability benefits. These benefits may be taxed to you under the rules that govern Social Security benefits.
How much coverage do you need? In deciding how much disability coverage you need to protect yourself and your family, you should take the tax treatment into consideration. If you’re buying the policy yourself, you only have to replace your “after tax” (“take-home”) income because your benefits will not be taxed. On the other hand, if your employer is paying for the benefit, keep in mind that you will lose a percentage of it to taxes.
Sometimes people have both an employer provided policy and purchase their own policy in order to ensure maximum disability payments in the case of an accident.