Tax Choice Disability

Disability insurance claim form
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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. When a company provides short-term disability benefits, the employee gets six months of coverage. Long-term benefits cover the employee for the duration of their disability or until they hit retirement age.

Who Pays for Disability Insurance?

As an employer, you can choose to pay for short-term disability and long-term disability coverage, put the burden of paying disability on the employee or 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.

If you as the employer choose to pay the premium, your employees won't be taxed on the premium amount 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.

Which Choice Makes Sense?

No perfect choice exists for any company. Some companies will offer both an employer-paid disability 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.

Employers that choose to pay the premiums help 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.

Any employer who wishes to provide employees with the opportunity to make after-tax contributions and receive their disability benefits on a tax-free basis needs to amend their Section 125 cafeteria plan and inform employees.

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 a cost employees would likely be glad to pay, as illustrated by the example below.

An Illustration

Assuming an employee makes $50,000 a year, falls in a 30-percent tax bracket and has disability coverage that will pay for 60 percent of salary upon disability 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 Take Home Pay: $35,000 per year (70 percent net take-home pay)

Employer-Paid

  • Disability Benefit (60 percent) $30,000 per year
  • Taxes: $9,000
  • Net Benefit if Taxed: $21,000 (60 percent of former take-home pay)

Employee-Paid

  • 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.