When it comes to disability insurance benefits, it’s always best to have them paid out on a tax-free basis.
Why? Because if you have the most common disability insurance policy – which covers 60% of your income up to $10,000 – and your benefits are taxable, that means instead of receiving $10,000 per month (in the 33% tax bracket) you’ll end up receiving only $6,700 per month after taxes.
In other words, the difference between the benefit you thought you had and the one you end up receiving could be the difference between having your needs met when you need them most and going into debt while trying to recover from your disability. What’s more, it could also mean missing out on retirement savings contributions.
But how can you make sure your benefits aren’t taxable?
There are a few ways to determine what will dictate the tax treatment of benefits. First, did you pay your premiums on a pre- or after-tax basis? If you paid your disability insurance premiums with after-tax dollars, then you can rest easy knowing your benefits will be tax free.
However, if your long-term disability insurance is provided through your employer it might be another story. Many employers provide such benefits on a pre-tax basis, which means that the employee who receives the benefit does not pay taxes on the value of the premiums. In those cases, the benefits likely are taxable.
Strategies for shielding disability insurance benefits from tax
First of all, if you have long-term disability insurance through your employer you can ask them if there is an option to “GROSS UP” your premiums. By doing so, you would pay income tax on the premium but your benefits would then be tax-free.
However, if you don’t have employer long-term disability or if you don’t have the option to make it a tax-free benefit (as described above), then consider supplementing with an individual disability insurance plan to subsidize your income protection. An individual supplement can cover the losses from taxes imposed on the employer-provided coverage.
In many cases, if you own a disability insurance policy that pays up to 60% of your income as a taxable benefit, most insurance companies are willing to increase that amount to 67% or even 75% to help you make up for the taxable portion of your underlying benefit.
Tax-free disability insurance for business owners
For the same reasons as above, we highly-encourage tax-free disability insurance benefits for yourself and for your employees.
If you’re a small-to-medium-sized business owner and you purchase an individual policy for yourself, that policy would not be deductible as a business expense. This means your disability insurance benefits would be tax free.
What if you need to purchase long-term disability insurance for your employees? In that case, you have a few options. First, you can either write it off as a business expense, which would make the benefits taxable for all your employees, or you can forego the deduction of the disability insurance premium. This would keep the benefits tax-free for your employees.
There’s another option. Under IRS rules, a business owner may be able to compensate employees for the cost of long-term disability insurance premiums, which the employees then pay themselves. By doing so, the premiums become taxable income for the employees, as well as deductible wage expenses for the business, all while ensuring that the benefits of the plan will be sheltered from income tax.
What about business overhead expense disability insurance?
Business owners should be aware of another type of tax-advantaged disability coverage they can use to protect their business. So-called business overhead expense (BOE) disability insurance covers rent, wages, and other fixed expenses in the event that a business owner becomes disabled. Such plans are intended for small businesses that rely on a few key people for all their operations. Their benefit periods tend to be fairly short – just a year or two – but they can be an important lifeline for a small business.
The premiums of a BOE plan typically are deductible as a business expense. However, their benefits are usually taxable as income. Since the policy is reimbursing the business owner for fixed business expenses, which are generally tax deductible, the end result is a break even between the taxable disability insurance benefits and the deductible business expenses. A business drawing from a BOE plan will want to work with a tax advisor to find offsetting losses.
Contact me for help navigating the world of disability insurance
Was that helpful? Let me know if you have any further questions about disability insurance benefits. I’m always eager to help you get the most out of your policy. Give me a call at (661) 803-6131 or send me an email at firstname.lastname@example.org to get started.