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|
Employer pays premiums
|Tax Deductible by Employer||Taxable to Individual|
Individual pays premiums
|Non-Deductible by Individual||Tax Exempt to Individual|
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?
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).
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