Midlands Business Profiles

Disability Insurance: Beware of Taxes

The Problem: Benefits are not what they seem

You know the feeling you get when you are absolutely certain that something works in a particular way? You begin to take for granted that what you believe to be is the honest truth – and then years later, when you least expect it, you learn that you were wrong the entire time. Maybe you received the misinformation years before, but you never had reason to question its validity. Unfortunately, financial planners see this all too often with the case of clients and their disability insurance. Maybe you own disability insurance because you prudently purchased a policy or two (or three) after you heard all the common statistics such as:

  • A 30-year-old man has a one in five chance of suffering a long-term disability before his planned retirement.
  • A 30-year-old woman has a one in three chance of suffering a long-term disability before her planned retirement.
  • Roughly 50 percent of people who suffer disabilities lasting longer than six months remain disabled after five years.
  • More people lose their homes through disability than through fire or death.
  • One in seven employees will be disabled for five years or more before retirement.

 

Event

Frequency

Home fire

1 out of every 88 homes

Serious auto accident

1 out of every 70 autos

Death

1 out of every 106 people

Disability

 1 out of every 8 people

 

Perhaps you own the policy and you are the beneficiary or maybe your employer or practice owns the policy and you are the beneficiary. One of your benefits of being an employee is that your employer pays the premiums for your policy and you are the beneficiary. If you own your own practice, you might choose to have the practice pay the premiums for your policy. In either case, you are the beneficiary of a disability policy for which you do not have to pay the premiums. The problem with this seemingly great deal is that any benefits you receive from this policy will be taxable as income in the year in which you begin to receive them. At the time you most need the income, you must pay taxes on the benefits you receive from your policy.

The Solution: Pay small amount of taxes up front

Now that you have begun to question the “great deal”, what do you do? Having your employer (or your practice) pay your premiums is fine; however, it is a good idea to ask your employer to add your premium to your W-2 at the end of each tax year. The IRS has ruled in Section 105 of the Income Tax Regulations that disability insurance premiums paid with pre-tax dollars will yield benefits taxed as income. Section 1.104-1(d) of the Income Tax Regulations states that if an individual purchases a policy of accident or health insurance out of his own funds, benefit amounts subsequently received are excluded from taxable income.  

Be sure to have the premiums you have not paid with after-tax dollars added to your W-2 for years going forward. If you are concerned about how past years of not paying taxes on your benefits will affect your potential future disability benefit taxation, you are not alone. Please verify with your tax advisor regarding the impact of pre-tax disability premium payments.  To obtain a form to present to your employer or human resources department, please visit the Abacus Planning Group website.

For more information on this portion of the tax code, please see Section 105 and Section 1.104-1(d) of the Internal Revenue Code located at www.irs.gov.

Eddie W. Kramer, CFP® serves as a Financial Advisor on the financial planning team of Abacus Planning Group, Inc.  In this capacity, he works closely with clients to understand their goals in order to develop and implement a comprehensive financial plan to achieve those goals.  www.abacusplanninggroup.com