Disability Benefits – Taxability
Income you receive from disability income insurance may or may not be taxable. If any portion is taxable, you must report that portion on your IRS Form 1040, FTB Form 540 or other State income tax form. Generally, taxability of your disability benefits will depend upon (1) the type of benefit(s) you receive, (2) whether the insurance premiums were paid with pretax or after-tax dollars, and (3) who paid the premiums (you or your employer – or a combination of both).
Here is a link to a chart that helps explain the following.
Individual disability income insurance
Individual disability income insurance benefits taxability rules are straight-forward. Since you are paying your premiums with after-tax dollars, all of your benefits are not taxable. However, you cannot deduct the premiums you pay for individual disability income insurance as a medical expense.
If your employer pays for an individual disability insurance policy on you (for example, if you are considered to be a key employee of the business), different rules may apply depending on who will get the benefits under the policy. If payments are made to the employer, then the premium is not deductible by the employer and the benefits are not taxable when the employer receives them.
Employer-sponsored group disability insurance
Taxability under employer group disability insurance plans depends on who pays the premium. If you pay the total premium using after-tax dollars, your benefits are tax free. If your employer pays the total premium (and your employer’s payments are NOT included in your W-2), then you will pay tax on all benefits you receive.
If your employer pays part and you pay the balance of the premiums, part of your benefits will be taxable. You will pay tax on the portion of the benefit related to the employer-paid share of the premium is taxable. In other words, if you pay 50% of the premium with after-tax dollars and your employer pays 50% of the premium, then 50% of the benefits will be taxable.
Benefits under a cafeteria plan
Under an employer-sponsored cafeteria plan, employees are able to select among certain employee benefits, including health, life, and disability insurance. Usually employees pay for these benefits on a pretax basis. Sometimes, however, your employer pays the premium for the benefits you choose (up to a certain amount), and if you choose additional benefits, you pay for extra coverage using either pretax or after-tax dollars.
If you pay your share of the premium with after-tax dollars, that portion of your disability benefits will be considered tax-free income; you’ll be taxed only on the portion of the benefit related to your employer’s contribution. However, if you pay your share with pretax dollars, that portion of your disability benefits will be considered taxable income, and you’ll have to pay income tax on all of your benefit.
You may be able to claim a tax credit if you are totally and permanently disabled, and you receive fully or partially taxable disability benefits from an employer-sponsored disability insurance plan.
Group association disability insurance
Policies for disability insurance that are purchased through an association are called group policies because members of the association are offered special terms, conditions, and rates based on the characteristics of that group. Association policies are treated like individual policies with similar tax consequences. If you pay the premiums for an association policy, the benefits you receive are tax free, but you cannot deduct the cost of the premiums.
Government disability insurance
All, part, or none of the disability benefits you receive through government disability insurance programs may be taxable. How much of the benefit is taxable (and under what circumstances) depends on the type of government disability benefit you are receiving:
Social Security benefits: If the only income you had during the year was Social Security disability income, your benefit usually isn’t taxable. However, if your total income exceeds a certain base amount and you earned other income during the year (or had substantial investment income), then you might have to pay tax on part of your benefit. More specifically, your Social Security benefit is taxable if your modified adjusted gross income plus one-half of your Social Security benefit exceeds the base amount for your filing status.
Medicare benefits: When you are disabled, you may be eligible to enroll in Medicare. If you pay premiums for the medical insurance portion of Medicare, you may deduct these premiums as a medical expense (provided, of course, that your medical expenses exceed 7.5 percent of your adjusted gross income). In addition, Medicare benefits you receive are not taxable.
Workers’ compensation: Generally, if you receive a disability benefit from workers’ compensation, that benefit won’t be taxable. Any benefits paid to your survivors would also be tax exempt. However, in certain cases, you may be able to return to work and continue to receive payments. If this is the case, then your workers’ compensation benefit would be taxable. Note, though, that if part of your workers’ compensation benefit offsets (reduces) your Social Security benefit, then that part is considered to be a Social Security benefit. It may then be taxable according to the rules governing Social Security.
Veterans benefits: Disability benefits you receive from the Department of Veterans Affairs, (previously known as the Veterans Administration), are not taxable, except for certain payments for rehabilitative services.
Military benefits: Most military disability pensions are taxable. However, if you were disabled due to injury or illness resulting from active service in the armed forces of any country, your disability benefits may be tax free under certain conditions.
Federal employees retirement system (FERS) benefits: If you retire on disability, the payments under FERS that you receive from a pension or annuity are taxable as wages until you reach minimum retirement age. However, beginning the day after you reach minimum retirement age, your payments are taxable as a pension.
Is it wiser to buy disability coverage with pretax or after-tax dollars?
It depends. Remember that if you pay your premiums for disability income insurance with pretax dollars, you are reducing your current taxable income. This means that you won’t have income taxes withheld on the portion of your income you used to pay your disability income insurance premium. However, you also have to consider how your benefit would be taxed if you ever begin receiving disability benefits. That is because if you use pretax dollars to pay your insurance premium, then your benefit would be fully taxable. However, if you use after-tax dollars, your benefit won’t be taxable.
Here is the bottom line! If you never use your disability benefits, you’ll save money by paying your premiums with pretax dollars. But if you do use your disability benefits, using after-tax dollars to pay your premiums places you in a better position.
Special Rules for Police Officers/Firemen
The IRS issues a Private Letter Ruling addressing the issue of disability retirement payments to police officers and firemen. This appears to mirror the ‘Ventura Decision” issues many years ago that concluded retirement payments made to a police officer who was injured in the line of duty did not constitute gross income. Private Letter Rulings cannot be cite as legal precedent; however, the logic Chief Counsel uses in reaching the conclusion can certainly be considered in advance an argument for non-taxability.
Private Letter Ruling 201025038, 6/25/2010, IRC Sec(s). 104
UIL No. 104.02-00
Income exclusions—line-of-duty disability benefits—police officers and firefighters.
Line-of-duty disability benefits paid to police officer or firefighter member who suffers disability due to job-related illness or injury, and which are paid as lifetime disability benefits or as continuation to survivor, won’t be considered gross income to recipient under Code Sec. 104(a)(1); .
Reference(s): Code Sec. 104;
Number: 201025038 Third Party Communication: None
Release Date: 6/25/2010 Date of Communication: Not Applicable Index Number: 104.02-00
Person To Contact: —————————————, ID No. ———————— ———————————————————————— ————————- —————————————————————————————
Telephone Number: ———————————————- ——————————- ——————-
Refer Reply To: ———————————————————
March 22, 2010
Taxpayer = —————————————————————————————— —————————————————————————-
State = —————
Statute = ————————————————————————————————————————————- ——————————————————
Act = ———————————————————————————
This is in reply to a letter dated October 14, 2009, and subsequent correspondence from your authorized representatives, requesting rulings on behalf of Taxpayer, concerning the federal income tax treatment of certain disability benefits paid pursuant to Statute and Act.
Taxpayer administers the payment of retirement and disability benefits for member police officers and firefighters employed by cities, towns and counties in State. Benefits are also available to qualified survivors of deceased members.
Section 12(g)(2) of Statute, as amended by Act, provides that a fund member who is receiving disability benefits based on a determination under this chapter that the fund member has a Class 1 or Class 2 impairment; is entitled to receive a disability benefit for the remainder of the fund member’s life in the amount determined under the applicable sections of this chapter.
Class 1 and Class 2 impairments are the direct result of an injury or illness incurred in the line of duty and benefits are not based on age, length of service or prior contributions. Section 13.5(b) and (c) of Statute.
Section 13.5(g) of Statute, as amended by Act, provides that benefits for a Class 1 impairment as determined under this section are payable for the remainder of the fund member’s life.
Section 13.5(h) of Statute, as amended by Act, provides that benefits for a Class 2 impairment are payable: (1) for a period equal to the years of service of the member if the member’s total disability benefit is less than thirty (30%) of the monthly salary of a first class patrolman or firefighter in the year of the local board’s determination of impairment and the member has fewer than four (4) years of service; or (2) for the remainder of the fund member’s life if the fund member’s benefit is (A) equal to or greater than thirty percent (30%) of a first class patrolman or firefighter in the year of the local board’s determination of impairment; or (B) less than thirty percent (30%) of the monthly salary of a first class patrolman or firefighter in the year of the local board’s determination of impairment if the member has at least four (4) years of service.
Section 23 of Statute was added by Act and provides:
(a) This section applies to a fund member who:(1) after June 30, 2009, receives a benefit based on a determination that the member has a Class 1 or Class 2 impairment, regardless of whether the determination was made before, on, or after June 30, 2009; and(2) before July 1, 2009, has not had the member’s disability benefit recalculated under section 13.5 of this chapter.(b) Upon becoming fifty-two (52) years of age, a fund member receiving a Class 1 impairment benefit or Class 2 impairment benefit under section 13.5(h)(2) of this chapter is entitled to receive a monthly supplemental benefit determined in
STEP THREE of the following formula:
STEP ONE: Determine the greater of:
(A) the monthly retirement benefit payable to a fund member with twenty(20) years of service; or(B) the monthly retirement benefit payable to a fund member with the total years of service (including both active service and the period, not to exceed twenty (20) years, during which the member received disability benefits) and salary, as of the year the fund member becomes fifty-two (52) years of age, that the fund member would have earned if the fund member had remained in active service until becoming fifty-two (52) years of age.
STEP TWO: Subtract from the amount determined under STEP ONE the amount of any monthly benefit determined under section 13.5 of this chapter that the fund member is entitled to receive for the remainder of the fund member’s life.
STEP THREE: Determine the greater of the following:
(A) The remainder determined under STEP TWO.(B) Zero (0).(c) A monthly supplemental benefit determined under this section is payable for the remainder of the fund member’s life.
Section 104(a)(1) of the Internal Revenue Code (the Code) states that, “Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc. expenses) for any prior taxable year, gross income does not include—(1) Amounts received under workmen’s compensation acts as compensation for personal injuries or sickness… .”
Section 1.104-1(b) of the Income Tax Regulations states that section 104(a)(1) excludes from gross income amounts that are received by an employee under a workmen’s compensation act or under a statute in the nature of a workmen’s compensation act that provides compensation to employees for personal injuries or sickness incurred in the course of employment. Section 104(a)(1) also applies to compensation which is paid under a workmen’s compensation act to the survivor or survivors of a deceased employee. However, section 104(a)(1) does not apply to a retirement pension or annuity to the extent that it is determined by reference to the employee’s age or length of service, or the employee’s prior contributions, even though the employee’s retirement is occasioned by an occupational injury or sickness.
Accordingly, based on the representations made, and authorities cited above, we conclude as follows:
(1) Line-of-duty disability benefits paid under sections 12(g)(2) and 13.5 of Statute, as amended by Act, to a member who suffers a disability due to a job-related illness or injury and which are paid as lifetime disability benefits (or as a continuation to a survivor) will not be considered gross income to the recipient under section 104(a)(1) of the Code.(2) The monthly-supplemental benefit paid to a member under section 23 of Statute, as added by Act, will be considered gross income to the recipient.
No opinion is expressed or implied concerning the tax consequences under any other provision of the Code or regulations other than those specifically stated above.
These rulings are directed only to the Taxpayer who requested them. Section 6110(k)(3) of the Code provides that they may not be used or cited as precedent.
Chief, Health and Welfare
Office of Division Counsel/Associate
Chief Counsel (Tax Exempt & Government Entities)
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