The Internal Revenue Service (IRS) taxes disability insurance benefits from individually owned policies as well as group- and government-sponsored plans. The determining factors of taxing disability payments depend on the insurance plans and how they are funded or how much the applicants earn. The amount of disability benefits that are considered taxable compensation is over 80 percent in some cases.
About Disability Insurance
Disability insurance protects the insureds’ incomes by paying benefits while they are out of work due to injuries or illnesses. The debilitating injury must not have happened at work, or it will be a worker's compensation claim. There are two main types of disability plans available: Short-term and long-term disability. Short-term disability (STD) generally pays benefits ranging from a couple of weeks up to two years, while long-term disability (LTD) pays for two years and longer.
Benefit amounts vary from insurer to insurer, but most STD and LTD plans cover about 60 percent of the insureds’ earnings. No disability policies will cover 100 percent, otherwise, there would not be any incentive for individuals to get back to work. Employees usually pay into their own disability coverage.
About Worker's Compensation
Worker's compensation is a form of state-specific insurance that covers employee injuries that occur at the workplace or while working. It is similar to STD because worker's compensation covers disabilities that prevent employees from working, but the injury must have been sustained on the job during the regular course of work. An injured employee can not receive both disability insurance and worker's compensation payments for the same injury.
Worker's compensation pays about 67 percent of regular compensation and reimburses medical costs to the employee. Employers cover the cost of worker's compensation insurance as required by law. Many disability insurance policies stipulate that employees must seek worker's compensation if the injury occurs at work.
About Social Security Disability
The Social Security Administration, a federal government agency, runs a disability program as well. Disability payments from this program are entitled to all American citizens who meet the agency’s criteria of disability: medical conditions that last longer than a year and prevent individuals from doing work they were previously employed for. This program doesn’t cover short-term or partial disabilities.
Benefit amounts depend on how much the workers paid into Social Security and their lengths of employment. Each eligible worker is notified each year of how much he could expect in Social Security payments if he were to become disabled.
Taxation of Disability Payments
The IRS taxes individual and group-sponsored disability benefits based on how the insurance premiums are paid. If premiums are satisfied with pretax dollars, then benefits paid from those disability plans are considered taxable incomes. However, disability coverages funded with after-tax dollars will pay out tax-free benefits. Group plans are typically funded with pretax dollars, while money previously taxed is used to pay individually owned disability policies.
Taxation of Worker's Compensation
Worker's compensation benefits are not taxable as income at the state or federal levels. However, if the recipient also receives certain Social Security benefits, they may have to pay tax on a portion of their benefits. If an employee is forced to retire due to the extent of the debilitating injury, then taxes may be due on retirement benefits. If an individual previously deducted medical costs that were later reimbursed by worker's compensation, that reimbursement might be treated as income, according to H&R Block.
Taxation of Social Security Disability Payments
The taxation of Social Security Disability benefits is based on the amount of the individuals’ total income from all sources as well. For example, individuals who have combined incomes, including payments from Social Security Disability, of over $25,000 will have their benefits taxed. Between $25,000 and $34,000, about 50 percent of the benefits are taxed by the IRS. Combined incomes of over $34,000 will result in up to 85 percent of the disability benefits being subject to taxation.
For married couples, taxation of their benefits begins when their combined incomes cross $32,000. Incomes between $32,000 and $44,000 will result in 50 percent of the disability benefits being taxed and up to 85 percent for earnings over $44,000.
Disability benefits are taxed at normal tax rates found on Form 1040.