Long term disability benefits can be an important source of income when a medical condition prevents you from working. But many claimants are surprised to learn that the monthly benefit listed in the policy may not be the amount they actually keep.
Whether LTD benefits are taxable usually depends on how the insurance premiums were paid. If the premiums were paid with pre-tax dollars, the benefits are generally taxable. If the premiums were paid with after-tax dollars, the benefits are generally not taxable. If both the employer and employee paid part of the premium, then only part of the benefit may be taxable. This is the general rule but unique circumstances exist, so you should always talk with a qualified tax professional.
IMPORTANT: Because tax treatment can depend on your specific payroll records, plan documents, and benefit arrangement, you should always speak with a qualified tax professional about your individual situation. Riemer Hess does not provide tax advice.
The most important question is usually who paid for the LTD coverage and whether those premium payments were made with pre-tax or after-tax dollars.
In many employer-sponsored LTD plans, the employer pays the full premium. The employee does not pay income tax on that employer-paid coverage when the premium is paid. As a result, if the employee later receives LTD benefits, those benefits are usually taxable as income.
In other plans, the employee pays the full premium through payroll deductions. If the employee pays those premiums with after-tax dollars, the LTD benefits are usually tax-free.
Some plans involve a shared arrangement. The employer pays part of the premium, and the employee pays part of the premium. In that situation, the taxability of the benefit is usually divided based on who paid what portion of the premium and whether the employee’s share was paid with after-tax dollars.
Assume an LTD policy pays a monthly benefit of $10,000.
If the employer paid 100% of the premium with pre-tax dollars, the full $10,000 monthly benefit may be taxable.
If the employee paid 100% of the premium with after-tax dollars, the full $10,000 monthly benefit may be tax-free.
If the employer paid 60% of the premium and the employee paid 40% with after-tax dollars, then roughly 60% of the benefit may be taxable and 40% may be tax-free. In that example, about $6,000 of the monthly benefit may be taxable, while about $4,000 may be tax-free.
That difference matters. A claimant who expects to receive $10,000 per month may have a very different financial picture if the full amount is taxable.
Taxes can affect financial planning before and after you leave work. If your LTD benefits are taxable, you may need to plan for withholding, estimated tax payments, or a lower monthly net benefit than expected.
This can be especially important for professionals and executives whose policies provide a high monthly benefit. A policy may advertise a substantial benefit, but the take-home amount can be meaningfully lower if the benefit is taxable.
Before filing a claim, it can be helpful to review:
Your LTD policy or plan document;
Your benefits enrollment materials;
Your paystubs;
Your W-2 forms;
Payroll deduction records; and
Any documents showing whether LTD premiums were paid pre-tax or after-tax.
These records can help clarify whether your benefits are likely to be taxable.
Tax issues may also arise if an LTD claim resolves through a lump sum settlement. The tax treatment of a settlement can depend on several factors, including how the premiums were paid, what benefits are being settled, the wording of the settlement agreement, and how the payment is reported.
Before accepting or finalizing any LTD settlement, you should consult a qualified tax professional. Your disability attorney can help evaluate the claim, policy terms, and settlement structure, but a tax professional should advise you on the tax consequences.
This article is for general informational purposes only and is not tax advice. Riemer Hess does not provide tax advice.
If you are applying for LTD benefits, receiving monthly benefits, or considering a lump sum settlement, speak with a qualified tax professional about how your benefits may be taxed. A tax professional can help you understand whether your benefits are taxable, whether taxes should be withheld, and how to plan for your overall financial situation.