Can You Make 401(k) Contributions on Short-Term Disability Insurance Income?

A 401k plan is a defined contribution deferred compensation program that works through salary withholding. As such, you cannot generally contribute the money you earn from short-term disability insurance to a 401k account. But there is nothing preventing you from investing that money elsewhere and still maintaining some of the tax advantages of the 401k.

Short-term disability insurance protects a worker against an income shock due to illness or injury that prevents her from working. In many cases, employers pay for basic short-term disability coverage as an employee benefit. Short-term disability helps injured or sick workers pay their bills for a limited period of time, such as 90 days. After that time, long-term disability insurance often kicks in. Benefits in most instances are taxable to the employee, though the payments typically represent only a fraction of the workers pre-disability income.

From the workers' perspective, there are many advantages to using a 401k program. These include tax deferral. Money withheld from your paycheck to invest in a 401k program is not taxable, nor is interest or dividends earned within a plan. Purchases and sales do not generate any kind of capital gains liability. And because these plans are qualified under the Employee Retirement Income Security Act of 1974, or ERISA, they enjoy nearly unlimited asset protection in the event of a lawsuit. Additionally, many employers match a portion of employee contributions. However, you can enjoy many of these tax benefits by investing money in other vehicles as well.

One option is to take your short-term disability income and contribute to an individual retirement account, or IRA. A traditional IRA allows you to take a tax deduction for the year for your contribution, and the account grows tax deferred, just like a 401k. Congress provides substantial asset protection for IRAs on balances up to $1 million, and in some cases state governments provide even broader protections than that. You will pay income taxes on any withdrawals, just like with your 401k, but you will have access to a broader array of investment options. You will not, however, enjoy the benefit of an employer match on your contributions. You cannot make deductible contributions to a traditional IRA if your income is above a certain amount, however.

You can choose to save your money and increase your 401k contribution after you are able to return to work. You can also choose a Roth IRA, which allows more generous income limits for contributors. You cannot deduct Roth IRA contributions, but you don't have to pay income taxes on withdrawals, provided your contributions have been in the Roth IRA for at least five years.