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Many Americans rely on disability income benefits, but you might wonder about the tax implications. Whether or not these benefits are taxed depends on the source of the payments and who funded the coverage.

If your disability income is paid directly by your employer, it is generally taxed just like your regular salary and may be subject to federal income tax withholding. However, it might not be subject to Social Security tax, depending on your employer's disability plan.

Often, disability payments come from an insurance policy, either provided by your employer or purchased privately. If your employer paid for the policy, the income is taxed similarly to if it were paid directly by them. However, if you paid for the insurance, the benefits you receive are not taxable.

If your employer arranges for the insurance but you cover the premiums, the benefits are not taxed as long as the premiums are deducted from your taxable income. Essentially, the tax treatment of your disability benefits aligns with the tax treatment of the premiums you pay.

Illustrative example

Let’s say your salary is $1,050 a week ($54,600 a year). Additionally, under a disability insurance arrangement made available to you by your employer, $15 a week ($780 annually) is paid on your behalf by your employer to an insurance company. You include $55,380 in income as your wages for the year ($54,600 paid to you plus $780 in disability insurance premiums). Under these circumstances, the insurance is treated as paid for by you. If you become disabled and receive benefits under the policy, the benefits aren’t taxable income to you.

Now assume that you include only $54,600 in income as your wages for the year because the amount paid for the insurance coverage qualifies as excludable under the rules for employer-provided health and accident plans. In this case, the insurance is treated as paid for by the employer. If you become disabled and receive benefits under the policy, the benefits are taxable income to you.

There are special rules if there is a permanent loss (or loss of the use) of a member or function of the body or a permanent disfigurement. In these cases, employer disability payments aren’t taxed, as long as they aren’t computed based on amount of time lost from work.

Social Security disability benefits

This discussion doesn’t cover the tax treatment of Social Security Disability Insurance (SSDI) benefits. They may be taxed to you under the rules that govern Social Security benefits. These rules make a portion of SSDI benefits taxable if your annual income exceeds $25,000 for individuals and $32,000 for married couples.

State rules may differ

If you receive disability benefits, your state may or not tax them. Consult with an Axley & Rode advisor to find out and to discuss this issue further.

When deciding how much disability coverage you need to protect yourself and your family, consider the tax treatment. If you’re buying a private policy yourself, you only have to replace your “after-tax” (take-home) income because your benefits won’t be taxed. On the other hand, if your employer is paying for the benefit, keep in mind that you’ll lose a percentage of it to taxes. If your current coverage is insufficient, you may want to supplement the employer benefit with a policy you take out on your own.

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