Federal Disability Benefits
The Social Security Administration offers two programs that provide long-term disability income. Supplemental Security Income makes disability payments based upon financial need and is always untaxed. Social Security Disability Insurance (SSDI) pays benefits based on the Social Security taxes you've paid. Social Security benefits that are your sole income source are generally not taxable. Part of your SSDI benefits may be taxable if you also have other sources of income. The taxable amount depends on your total income and your tax filing status. Similar rules apply to railroad retirement disability benefits. Disability payments from the Department of Veterans Affairs are not taxable.
Other Non-Taxable Disability Payments
Many other sources of disability payments are not taxable, including public welfare funds; worker's compensation for occupational sickness or injury; damages awarded to compensate you for physical injury or sickness, excluding any punitive damages; "no-fault" car insurance disability benefits; and compensation for permanent disfiguration or loss of a body part or function. Accelerated death benefits from a life insurance policy for chronic or terminal illness and payments from long-term care insurance contracts for personal injury or sickness generally are not taxed, either.
You must pay taxes on employer-paid disability pension or annuity income you receive when you retire because of disability. You report these payments as wages until you reach the minimum retirement age for the pension plan. After reaching this age, your payments are treated as a pension income and may be partially tax-free to the extent they reimburse your taxed contributions to the pension or annuity. Disability payments for injuries from a terrorist attack are not taxable.
Disability Insurance Proceeds
Generally, you must pay taxes on long-term disability payments from an employer-paid accident or health insurance plan. If both you and your employer paid premiums, only the payments arising from your employer's premiums are taxable. If you paid all the premiums, exclude the disability payments from your taxable income. However, if you paid the premiums to an employer's cafeteria plan -- a plan where you choose the benefits -- and didn't pay taxes on those premiums, the disability payments are taxable.