Is private disability insurance taxable

Answer 1

Whether or not private disability insurance BENEFITS are subject to Federal income tax is based primarily on whether the PREMIUMS for that coverage were paid with pre-tax or post-tax dollars, by whom, and for how long.

DISABILITY COVERAGE PURCHASED OUTSIDE OF WORK

If you bought your own (non-group) disability insurance on your own -- that is to say, the plan was not sponsored by your employer/funneled through a business AND you paid the premiums all yourself -- then it's generally pretty simple: the benefits that policy pays out should not be taxable. This is because you were not allowed to deduct the premiums from your taxes (the IRS wouldn't let you), and since the premium was paid with post-tax income you will not be required to pay taxes on the benefits. Which is a pretty good deal.

DISABILITY COVERAGE PURCHASED THROUGH WORK

If the disability policy was purchased through a business (i.e. your employer), then it gets a little more complicated. In a nutshell, if the premiums were paid using after-tax income (AND that's been true for the three years immediately prior to your disability), then your benefits will be tax-free. Conversely, if the premiums were paid using pre-tax income (AND that's been true for the three years immediately prior to your disability), then your benefits will reportable as taxable income. If the way it was paid CHANGED during the three years leading up to the disability, then you need to refer to the "Three Year Rule", a set of IRS Regulations that explain how to pro-rate the percentage of benefit that is taxable in your specific situation.

Thanks to Section 125 Cafeteria/Premium Only "POP" Plans, it is often difficult for an employee to determine on his or her own what portion of the premiums were paid on a pre- vs. post-tax basis, so it is best to ask your employer. They can then go to the insurance carrier, their insurance broker, or their tax adviser to provide you with the information you need. If you are already receiving disability benefits, contacting the insurance carrier who issued your policy is probably your best source, since they would have verified the taxability of the benefit at the time they set up your claim (and if it IS taxable, ask them about withholding options so you are stuck with a huge tax bill come April!). Also, at the end of the year, the income you receive will appear on a W-2 Form either as taxable or non-taxable income. If you have reason to believe this was calculated in error or you wish to understand the rationale used, you should go to whomever issued the W-2 for more information.

On a slight tangent, a trend in the last several years is for the employer to allow each employee to CHOOSE whether their premiums are paid with pre- vs. post-tax monies. Each employee decides for themselves as to whether they should pay a little extra tax now and have a federal income tax-free benefit (should one be payable at a future time) or else chose to NOT pay tax on the premium now, thereby seeing to it that any benefits payable at a future time will be taxable. If given that opportunity, any accountant or insurance broker will tell you to ALWAYS choose to pay the little bit of extra taxes up front. The potential tradeoff is huge. Choosing to save a few dollars a year now in exchange for paying a ton of taxes later is the very definition of "penny wise and pound foolish" and is the rare tax break that you should try to avoid taking.