The Internal Revenue Service taxes disability insurance benefits from individually-owned policies as well as group- and government-sponsored plans. The determining factors depend on the type of insurance plans, how they're funded and how much the applicant earned. The amount that's considered taxable compensation can be over 80 percent in some cases.
About Disability Insurance
Disability insurance protects the insured's income by paying them benefits while they're out of work due to an injury or illness. The injury must not have happened at work. This would make it a worker's compensation claim instead.
There are two main types of disability plans: short-term and long-term. Short-term disability (STD) generally pays benefits ranging from a couple of weeks to up to two years, while long-term disability (LTD) pays for two years or longer.
Benefit amounts vary from insurer to insurer, but most STD and LTD plans cover about 60 percent of the insured's earnings. No disability policies will cover 100 percent, because that would eliminate any incentive for individuals to return 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's similar to STD because it 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't receive both disability insurance and worker's compensation payments for the same injury.
Worker's compensation 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 provides a disability program as well. All American citizens who meet the agency’s criteria of disability are entitled to payments from this program. Medical conditions must last longer than a year and they must prevent individuals from doing the work they were previously employed to do. 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 they could expect in Social Security payments if they 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. Benefits are considered taxable incomes if the premiums are paid with pre-tax dollars. But disability coverages funded with after-tax dollars 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 aren't taxable at either the state or federal levels, but the recipient may have to pay tax on a portion of their benefits if they also receive certain Social Security benefits. Taxes may be due on retirement benefits if an employee is forced to retire due to the extent of the debilitating injury. Reimbursement might be treated as income if an individual previously deducted medical costs that were later reimbursed by worker's compensation, 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’ income. Benefits become taxable when one-half of the amount received plus all other sources of income tops certain thresholds.
Individuals who have combined incomes of over $25,000 will have their benefits taxed as of 2021, the year for which you'll file a tax return in 2022. This increases to $32,000 if you're married and filing a joint tax return. Married taxpayers who file separate returns have a $0 threshold if they lived with their spouses at any time during the tax year.
You may have to pay tax on up to 50 percent of the benefits you receive if your combined income is between $25,000 and $34,000. This increases to 85 percent if your combined income exceeds $34,000. 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 ordinary income tax rates of 10, 12, 22, 24, 32 or 35 percent as of 2021, depending on your overall income.
- HR Block: Do You Claim Workers Comp on Taxes as Taxable Income?
- U.S. Department of Labor: Workers' Compensation
- IRS: Frequently Asked Questions / Regular & Disability Benefits
- Social Security Administration: Income Taxes and Your Social Security Benefit
- IRS: IRS Provides Tax Inflation Adjustments for Tax Year 2021