There are several types of disability insurance plans that pay benefits the Internal Revenue Service (IRS) considers taxable compensation. Such plans are sold privately by insurance companies or sponsored by employers and professional associations. State and federal government agencies also offer disability insurance coverage that pays taxable benefits to insureds.
Benefits of Disability Insurance
Workers purchase disability insurance to replace their incomes, temporarily or permanently, when they cannot work due to their injuries or illnesses. Disability plans fall into two categories: short-term and long-term. Short-term disability (STD) insurance plans pay workers for several weeks up to two years. Long-term disability (LTD) insurance provides coverage for several years or, in some cases, for the rest of the insured's life. An important fact about disability insurance plans is that they will not totally replace the lost income of the insured while he is out of work. Generally, disability benefits will cover 40 to 65 percent of the insured's pre-disability salary. This provides workers with an incentive to return to their jobs as soon as they can.
Taxing Disability Benefits from Group and Private Plans
Some common sources of disability coverage are through insurance companies, employers and professional associations. To obtain coverage, individuals must pay premiums charged by the insurance companies. However, the type of money used to satisfy these requirements determines if disability benefits are taxed by the IRS. Disability insurance plans pay taxable benefits if premiums are paid with pre-tax dollars. Individuals who purchase plans directly from insurance companies typically pay premiums with after-tax funds; therefore their disability income checks are not considered taxable compensation.
Taxing Benefits from Social Security
Social Security disability insurance, a publicly-funded program, provides benefit payments to individuals who meet the definition of disabled, have accrued enough work credits and have paid into Social Security when they were working. However, if they have other sources of income coming into the household, their disability benefits are subject to taxation. As of 2012, the IRS taxes 50 percent of the benefit at normal tax rates if the individual earns over $25,000 per year or, if married, over $32,000. Up to 85 percent of their benefits are taxed if individuals and married couples have incomes that top $34,000 and $44,000, respectively.
Taxing Benefits from State Disability Plans
Several states provide short-term disability coverage for their workers. The five states that sponsor disability plans that are funded through payroll taxes are Hawaii, New Jersey, New York, California and Rhode Island. Puerto Rico also provides similar coverage for its workers. Although these plans are paid for with after-tax dollars, some states pay benefits that must be reported on the workers' individual tax forms. For example, benefits paid from New Jersey's Temporary Disability Insurance program are not subject to state taxes but are considered taxable compensation for federal tax purposes.