Disability Insurance - Taxation of Premiums and Benefits

The taxability of disability income benefits is a pretty simple concept to master if you pay particular attention to "who pays the premiums".

When disability benefits are received for an employer-provided disability policy, these benefits are generally included as taxable income to the recipient. If the disability benefits are received from a policy where the individual made the premium payments, then the benefits are excluded from taxable income. Some hybrid disability policies exist; whereas, part is provided by the employer and the other part by the individual- in this case benefits will be includible in income to the extent of the employer pro rata share of premiums.

Structure of Disability Contract Tax Consequence of Premium Tax Consequence of Benefits Paid

Type A:
Individually Owned
Employer pays premiums
Tax Deductible by Employer Taxable to Individual

Type B:
Individually Owned
Individual pays premiums
Non-Deductible by Individual Tax Exempt to Individual

Practice Question:
Jim has a salary of $70,000 with Widget Corporation (S Corporation) which puts him in the 25% tax bracket. His employer gives Jim a bonus in the form of the cost of disability insurance (premium $4,000) which is added to Jim's W-2. If Jim becomes totally disabled, he is entitled to 60% of his salary in disability benefits. What is Jim's after-tax monthly disability benefit if he is in the 15% tax bracket during his disability?

A. $2,625
B. $2,975
C. $3,000
D. $3,500

Answer: D
Jim's employer pays Jim a bonus of $4,000 which is applied directly to disability premiums on an individual disability policy for Jim. Jim's W-2 income will reflect $74,000. Therefore, Jim will pay tax on the premium payments and is considered the premium payer and therefore will not be taxed on the monthly disability benefits. He would receive $3,500 per month tax-free ($70,000 x 60% divided by 12 months). Introduction to Long Term Care
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