From the premiums you pay to the checks you collect, it's important to understand the tax implications of disability insurance.
Potential buyers and policy owners alike often ask if disability insurance it's tax-deductible. In most cases, the answer is no.
However, there is good news. If you need to collect benefits from a personal disability insurance policy, you can expect to receive them tax-free in most scenarios. Still, be sure to consult a tax professional with any questions about the treatment of your policy's premiums and benefits.
In this article, we will cover:
- The tax treatment of disability insurance premiums
- The tax treatment of disability insurance benefits
Read on to learn more.
Are disability insurance premiums tax-deductible?
The premiums you pay for long term disability insurance are not tax-deductible. If you itemize deductions when you file your tax return, do not count your disability insurance premiums.
Some people mistakenly think that the tax treatment of disability insurance premiums is similar to those of medical insurance, which are deductible. Details about which medical expenses you can and cannot deduct are detailed in Publication 502.
According to the IRS, deductible medical expenses include payments for medical services. It also includes medical insurance premiums. You can also deduct amounts paid for long-term care services and “limited amounts paid for any qualified long-term care insurance contract.”
Publication 502 also lists insurance premiums you cannot deduct, some of which describe disability insurance. These include:
- Life insurance policies
- Policies providing payment for loss of earnings
- Policies for loss of life, limb, sight, etc.
- Policies that pay you a guaranteed amount each week for a stated number of weeks if you are hospitalized for sickness or injury
- The part of your car insurance that provides medical insurance coverage for people injured in or by your car
- Health or long-term care insurance if you elected to pay these premiums with tax-free distributions from a retirement plan made directly to the insurance provider and these distributions would otherwise have been included in income
One type of disability insurance premium that is tax-deductible
The closest you can come to deducting your disability insurance premiums is if you own a business.
For those who also have to be concerned with keeping their businesses running in the event of short-term or long-term disability, there is an option called business overhead expense insurance (or BOE for short).
Whereas regular disability insurance covers individual income, a business overhead expense policy will help cover monthly business expenses such as employee salaries, rent, utilities, maintenance, taxes, etc.
Premiums for this type of insurance are considered a business expense and are therefore tax-deductible. Overhead expense policies are specifically listed in IRS Publication 535, Business Expenses. Under the heading of deductible premiums, the document states:
“Overhead insurance that pays for business overhead expenses you have during long periods of disability caused by your injury or sickness.”
Keep in mind, however, that deductibility does not apply to a business owner who gets disability insurance to cover lost personal income. It only applies to insurance that covers business expenses.
What is a business overhead expense insurance policy?
Business overhead expense policies or riders help cover business expenses if a disability prevents or limits the owner of one of the owners from working. BOE is a necessity if you are a partial or full owner of a medical practice.
You can typically get BOE coverage that pays a maximum monthly benefit between $15,000 and $25,000. The maximum benefit period on BOE is typically two years. If you obtain BOE that is bundled with your personal disability policy, the maximum benefit may be a factor of that benefit amount. For example, the BOE benefit maximum might be equal to 12 times the benefit on your personal policy.
BOE benefits can help you cover:
- Rent or mortgage payments on your business facilities
- Employee salaries and wages
- Business loan repayments
- Business insurance premiums
- Equipment maintenance
- Building maintenance and janitorial services
- Office supplies
Do you pay taxes on disability insurance benefits?
The effect disability insurance payments have on your taxes depends on the type of policy, how premiums are paid, and who is paying the premium.
If you pay the policy’s premiums with after-tax dollars — meaning you don’t receive a tax break for those premiums — then any benefits you claim from the policy will be tax-free income. If you become disabled, you will not owe income taxes on the benefits you receive from your disability policy. This is true whether you’re buying a group plan through an association or your own individual policy.
However, you must report as income any amount you receive for a disability through an insurance policy paid for by your employer.
If you and your employer split the premium cost, then you must report as income the amount that is attributable to your employer’s payments.
For example, say your employer provides long-term disability insurance and pays 75 percent of the premium. You pay the other 25 percent. You become disabled and receive a $60,000 benefit the first year. You would have to report $45,000 of that benefit ($60,000 x 75%) as taxable income when you file your taxes. The remaining $15,000 is not taxable because you paid that share of the premiums with after-tax money.
However, if you pay part of the premium with pretax dollars, you’ll owe income tax on any disability benefit you receive. You often pay premiums on disability insurance with pre-tax dollars when it’s through a cafeteria or medical reimbursement plan.
That's for individual and group coverage. You may owe income tax on some, all, or none of the disability benefits received through government programs.
Social Security Disability Insurance
Income from Social Security disability isn’t taxable if your provisional income is less than the base amount. Provisional income is your modified adjusted gross income plus half of the Social Security benefits you receive. The base amount is $25,000 for individuals and $32,000 for joint filers.
If your provisional income exceeds your base amount, up to 50 percent of your Social Security benefits can be taxable. You can also be taxed on 85 percent of benefits is the base amount is at least $34,000 for individuals and $44,000 for joint filers.
Workers' compensation insurance
Workers' compensation payments are generally not considered taxable income if they are related to on-the-job injury or sickness. This is also true if you die on the job and your surviving beneficiaries receive benefits.
Workers' compensation can be considered taxable income in the event you return to work but continue receiving payments.
Also, any part of your worker's compensation benefit that reduces your Social Security benefit will be considered part of your Social Security benefits. In that case, the rules of Social Security taxation mentioned above will apply.
You may be able to enroll in Medicare while disabled. If you pay premiums for the medical insurance portion of Medicare, you can typically deduct the premiums as a medical expense. You are not taxed on Medicare benefits you receive.
Disability benefits for veterans collected from the Department of Veterans Affairs are not taxable. The one exception is for certain payments for rehabilitative services.
However, most military disability pensions are taxable. Your military disability benefits may be tax-free if you were disabled due to injury or illness resulting from active service.
Federal employees who retire on disability will owe taxes on the payments under the Federal Employees Retirement System (FERS).
Disability insurance is not protection to cover medical costs. It replaces income lost due to an injury or illness. That is why disability insurance premiums are not tax-deductible. But because you don’t receive a tax deduction for disability insurance, you receive policy benefits tax-free, provided you pay for the premiums.
Jack Wolstenholm is the head of content at Breeze.
The information and content provided herein is for educational purposes only, and should not be considered legal, tax, investment, or financial advice, recommendation, or endorsement. Breeze does not guarantee the accuracy, completeness, reliability or usefulness of any testimonials, opinions, advice, product or service offers, or other information provided here by third parties. Individuals are encouraged to seek advice from their own tax or legal counsel.