When an injury or illness takes away your ability to work, a disability check can be the thing that keeps the lights on. The question I get next is always the same: "Do I have to pay tax on this?"
The honest answer is that it depends, and it depends mostly on one fact you may never have thought about. Who paid the premiums for the coverage, and were those premiums paid with taxed or untaxed dollars? Get that right and the rest falls into place. Get it wrong and you can end up with an IRS balance on income you thought was tax free.
The general rule: follow the premiums
IRS Publication 525 lays out the framework. Three scenarios cover most people.
You paid the entire cost with after-tax money
Publication 525 says: "If you pay the entire cost of an accident or health plan, don't include any amounts you receive from the plan for personal injury or sickness as income on your tax return." It says the same thing in its discussion of sick pay: if you paid the premiums on an accident or health insurance policy, the benefits you receive under the policy are not taxable.
This is the classic individual disability policy you bought yourself and paid for from your checking account. The benefits are generally tax free.
Your employer paid the cost
Publication 525 also says pay you receive from your employer while you are sick or injured is part of your wages, and you must include sick pay benefits from an insurance company if your employer paid for the plan. Employer-paid long-term disability is the common example. Those benefits are generally taxable income.
You both paid
Where you and your employer share the cost, Publication 525 says "only the amount you receive that is due to your employer's payments is reported as income." The plan administrator or insurer can usually tell you the split.
The cafeteria plan trap
Here is the part most people miss. Many employees pay their disability premiums through payroll deductions and assume that makes them "their" premiums. It might not.
Publication 525 explains that if you are covered through a cafeteria plan and the premiums were not included in your income, "you aren't considered to have paid the premiums and you must include any benefits you receive in your income." In other words, if the premiums came out of your paycheck before tax, the IRS treats them as employer-paid. The benefits are taxable.
If the premiums were included in your income, because they were deducted after tax, you are considered to have paid them, and the benefits follow the "you paid" rule. Look at an old pay stub or ask human resources which way your plan worked. That single detail can swing the tax result on years of benefits.
Workers' compensation is different
If the disability is work-related and the payments come from workers' compensation, Publication 525 says amounts received "as workers' compensation for an occupational sickness or injury are fully exempt from tax if they're paid under a workers' compensation act or a statute in the nature of a workers' compensation act."
The exemption has limits. Publication 525 notes it does not apply to retirement plan benefits based on your age, length of service or prior contributions, even if you retired because of an occupational injury. And if you return to work and are paid for light duty, that pay is wages.
Disability pensions
If you retire on disability under an employer-funded plan, Publication 525 says you must include the disability pension in income. Until you reach minimum retirement age, which is generally the age at which you could first receive a pension if you were not disabled, Publication 525 says the taxable payments are reported on line 1h of Form 1040. After that, they are taxed as a pension or annuity, as explained in Publication 575.
Publication 525 also points out that you may be entitled to a tax credit if you were permanently and totally disabled when you retired, which is covered in Publication 524. Check it if your income is modest.
Social Security disability is its own topic
Social Security Disability Insurance benefits are taxed under a separate set of rules, and the lump-sum back payments that often come after a long approval process create their own problems. I cover those in SSDI back pay and taxes.
Withholding: where the IRS balance usually comes from
Taxable disability benefits paid by an insurance company often have no income tax withheld unless you ask. That is how people end up owing. The benefits feel like a replacement paycheck, but they arrive without a paycheck's withholding.
The IRS has a form for this. Form W-4S, Request for Federal Income Tax Withholding From Sick Pay, is what you give to a third-party payer of sick pay, such as an insurance company, if you want federal income tax withheld. If you do not want withholding, plan for estimated tax payments with Form 1040-ES.
There is also some penalty relief if you get it wrong in the first year. IRS Tax Topic 306 says the IRS may waive the estimated tax underpayment penalty if you became disabled during the tax year or the preceding year and the underpayment was due to reasonable cause and not willful neglect. That waiver is not automatic, and it covers the penalty, not the tax.
A worked example
Two coworkers, same employer, same long-term disability policy, same diagnosis, same $3,000 monthly benefit.
- Coworker A elected to pay the premiums with after-tax payroll deductions. The premiums were included in her wages. Under Publication 525, she is considered to have paid them. Her benefits are generally not taxable.
- Coworker B paid the same premium through the cafeteria plan, pre-tax. Under Publication 525, he is not considered to have paid them. His $36,000 a year in benefits is generally taxable income.
Same check. Different tax. And coworker B, if no one withheld, may owe the IRS in April.
Now add one more wrinkle. Suppose coworker B also has a small individual policy he bought years ago and paid for from his own checking account. Those benefits follow the "you paid" rule and are generally not taxable, even though his group benefits are. One person, two policies, two different answers. Treat each source of disability income separately, and keep a short note in your tax file explaining why each one is or is not on the return. If the IRS ever asks, that note and the premium records will answer the question in a page.
What to do now
- Find out how the premiums were paid. Ask the plan administrator or HR, and keep the answer in writing.
- Look at the tax forms you receive. Compare whatever information return the payer issues with your own record of payments and any tax withheld.
- Set up withholding or estimated payments if the benefits are taxable.
- Check related rules. A qualifying disability may also remove the 10% additional tax on early retirement withdrawals. See the disability exception to the early withdrawal tax.
- Ask for accommodations if you need them. The IRS offers help for taxpayers with disabilities. See IRS help for taxpayers with disabilities.
The bottom line
Disability benefits are not automatically tax free, and they are not automatically taxable. Who paid the premiums, and whether those premiums came out of taxed or untaxed pay, usually decides it. Workers' compensation is generally exempt. Employer-paid and pre-tax cafeteria plan benefits are generally taxable.
Figure out which one you have before the first return, not after the first notice.
Frequently asked questions
Are long-term disability benefits taxable?
It depends on who paid the premiums. Under IRS Publication 525, benefits from a policy you paid for entirely with after-tax money are not taxable. Benefits from an employer-paid plan are generally taxable. If you both paid, only the part due to the employer's payments is income.
I paid my disability premiums through payroll. Are my benefits tax free?
Not necessarily. Publication 525 says that if premiums were paid through a cafeteria plan and were not included in your income, you are not considered to have paid them, and the benefits are taxable. If the premiums were deducted after tax and included in wages, you are treated as having paid them.
Is workers' compensation taxable?
Generally no. Publication 525 says workers' compensation for an occupational sickness or injury is fully exempt if paid under a workers' compensation act or similar statute. The exemption does not cover retirement benefits based on age, service or prior contributions, or wages for returning to work.
How do I get tax withheld from disability checks?
Give Form W-4S, Request for Federal Income Tax Withholding From Sick Pay, to the third-party payer, such as the insurance company. If you prefer not to have tax withheld, make estimated tax payments using Form 1040-ES so the benefits do not create a balance due.
This guide is general information, not legal advice. Tax law changes and every case turns on its own facts.