Tax Planning with Respect to Disability Insurance

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Author: Charles F. Fuller

No one wants to become disabled, but when a disability arises that prevents you from working, the existence of disability insurance could provide you with an income stream during the period of disability. Often, people are provided short term and long term disability insurance coverage through their employment as part of their employee benefit package. Other times, people purchase individual disability insurance policies. Under either scenario, it is helpful to consider the tax effects of such disability coverage at the time that you obtain it and before you become disabled.

For individual policies where premiums are paid by the policyholder, the premiums are usually paid with after-tax dollars and therefore any disability benefits that you receive under the policy are not taxable for federal or state income tax purposes. This is rather straightforward and does not require much tax planning.

In situations in which an employee is provided disability coverage through employment, the employee should inquire with the employer regarding the tax consequences of this employee benefit should you be required to use it. In other words, you should ask your personnel or human resources department if there is a way to ensure that benefits you may receive as a result of disability under this policy can be received free of any income tax liability. Some employers have thought about this issue prior to implementing their employee benefit plan, while others have not. As a general rule, if the disability insurance premium is paid after being deducted from the employee’s paycheck (after tax dollars), any resulting disability benefits received should be free of tax. If the premium is paid with pre-tax dollars, either from a cafeteria plan[1] or deducted from your pay by your employer before taxes are deducted, any disability benefits received will most likely be taxable. If you have disability coverage, you should investigate now whether there is a way to ensure that your benefits would be free from income tax liability if you become disabled and receive benefits. It is important to investigate and plan for this contingency before you become disabled to determine if you can have greater resources (through tax-free disability benefits) should you become disabled.

[1] A cafeteria plan is an IRS-approved reimbursement plan which allows employees to contribute a certain amount of their gross income to one or more designated accounts before payroll taxes are computed. The account(s) can be used to pay for insurance premiums, medical and/or dependent care expenses not covered by insurance.

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