How to Choose Your Company's Disability Insurance
People don't typically think about falling ill or getting hurt on the job. But when an employee suffers a disability, they're hoping that at least a portion of their salary will be covered. This is where disability insurance comes in. Whether you offer a comprehensive benefits package or a smaller one, it is an important thing to consider.
When a company provides short-term disability benefits, the employee gets six months of coverage. Long-term disability benefits cover the employee for the duration of their disability or until they hit retirement age.
Options for Who Pays for Disability Benefits
As an employer, you can choose from the following:
- Pay for short-term disability and long-term disability coverage
- Put the burden of paying disability on the employee
- Share the cost of coverage
More and more employers are choosing to share the cost of coverage or have employees pay the cost of disability insurance due, in part, to recent IRS regulations that make it easier to do so.
No perfect choice exists for any company. Below are some options in more detail.
Offer both an employer-paid plan and an employee-paid disability plan.
Companies often refer to this as tax choice. Other companies do not give employees the choice and end up choosing the plan they hope will best fit their employees.
Choose to pay the premiums.
This helps employees avoid the costs of disability premiums. But, should any employee go out on disability, they become responsible for taxes on any income they receive. When employees pay the cost of their own disability premiums through payroll deductions, the disability benefits they receive are not taxed if they subsequently become disabled.
How Your Employees' Taxes Will Be Affected
Choosing the right insurance for your employees is one thing, but each of your options has different effects on your taxes you should also take into consideration.
If you choose to pay the premium, your employees won't be taxed.
They won't be taxed under IRS Code Section 106. However, under IRS Code Section 125, if you choose to shift the cost to employees, they pay the premium on a pre-tax basis through payroll deductions. In turn, employees would be able to collect disability tax-free if they qualified for disability.
Provide employees with the opportunity to make after-tax contributions.
This way, they can receive their disability benefits on a tax-free basis, but they would need to amend their Section 125 cafeteria plan and inform employees.
Taxes on Disability Income vs. Premium Costs
While most employees would prefer to have their employer pay the premium costs; that may not be the case should they go out on disability. Premium costs are minimal but when you compare that to the costs of taxes on disability income, it’s something any employee would likely be glad to pay, as illustrated by the example below.
An Employer Paid vs. Employee Paid Example
Let's take this situation assuming an employee makes $50,000 a year. They fall in a 30 percent tax bracket and have disability coverage paying 60 percent of their salary with a premium equal to 28 cents for every $100 of employee income.
- Pre-Disability Income: $50,000
- Taxes on Income: $15,000 (Federal, State, FICA: 30 percent in taxes)
- Net Pay: $35,000 per year (70 percent net pay)
- Disability Benefit (60 percent) $30,000 per year
- Taxes: $9,000
- Net Benefit if Taxed: $21,000 (60 percent of former take-home pay)
- Disability Benefit (60 percent) $30,000 per year After-Tax
- Premium at $50,000: $140 per year ($50,000 x 0.28/$100)
- Net Benefit if Not Taxed: $21,000 (60 percent of former take-home pay)
In this example, you can see the savings an individual who goes out on disability would have if they pay their premium costs and all taxes on it.
Of course, for those who don’t go on disability, they would shell out $140 extra a year in this particular example, if they did not go on disability. This is why many companies give employees the choice of how they would like to pay premiums.