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Disability Insurance: How to Create Tax-Free Income Replacement

Financial Planning

May 2015

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Disability Insurance: How to Create Tax-Free Income Replacement

Disability insurance has traditionally been offered in two forms: short-term (typically from 90 days to a year) and long-term (beginning after 90 days/year). Some companies offer a base amount of disability coverage at no cost to employees, giving them the opportunity to purchase a higher level of coverage using their own salary or benefit dollars. As a general rule, the premium for the additional level of coverage is nominal compared to the benefit received should the worker become disabled.

For example, if an employer-sponsored portion provides 50 percent of salary benefit, the employee may be able to buy up additional protection to bring the total coverage to 60 percent. For someone earning an annual salary of $40,000, this would increase his monthly income payout from $1,667 to approximately $2,200.

Disability insurance is designed to cover only a portion of income – not all of it. The highest percentage of income replacement is generally 70 percent, but the actual take home amount may vary depending on income sources and tax status.

Also bear in mind that most policies place a maximum cap on how much disability income is paid out each month, ranging anywhere from $15,000 to $40,000. Most group disability policies further complicate the issue by replacing only base income. In other words, an annual bonus would not be factored into the income calculation.

Disability payouts can shrink even further depending on tax status. When an employee is enrolled in a group disability insurance plan sponsored by his employer, if he pays the total premium using after-tax income, then his benefits will be tax free. On the other hand, if the employer pays the total premium and does not include the cost of coverage in the employee’s gross income, then the benefits will be taxable.

Many times the cost is split between the employer contribution for base coverage and the employee contribution for additional coverage. In this scenario, if the employee pays his share of premiums with after-tax dollars, that portion of his disability benefits will tax-free income. He will be taxed only on the portion of the benefit related to the employer’s contribution. However, should the worker pay his share with pre-tax dollars, the entire disability benefit will be taxable.

Bear in mind that an employee who becomes totally and permanently disabled and receives taxable disability benefits from an employer-sponsored disability insurance plan may be eligible to claim a tax credit on his income tax return.

A worker can save money by paying his share of disability insurance premiums with pre-tax dollars. However, if he ever needs to use his disability benefits, he’d be better offer having paid with after-tax dollars so that taxes won’t decrease his income even further. In other words, to create a plan for tax-free income replacement, it may be worth it to purchase a disability insurance policy with taxable income.

Other Disability Benefits

Social Security: To qualify for Social Security disability benefits, you must be totally disabled, unable to work at any job, and your disability must be expected to last at least one year. Social Security disability income isn’t generally taxable unless your modified adjusted gross income (which may include investment income) plus one-half of your Social Security benefit exceeds the base amount for your filing status.

Workers’ Compensation: Generally, workers’ compensation disability benefits are not taxable. However, there are some situations in which the employee may be able to return to work and continue to receive payments. In this scenario, the workers’ compensation benefit is taxable.

In general, veteran’s disability benefits are not taxable, with the exception of certain payments for rehabilitative services. Military disability pensions are taxable unless the recipient became disabled due to injury or illness resulting from active service, in which case benefits may be tax free under certain conditions.

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These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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