Generally, all income you receive is taxable, unless it's expressly exempted. Exemptions include worker's compensation payments and damages awards received through litigation. However, income received from disability insurance isn't exempt and may or may not be taxable. Whether disability insurance benefits are taxable depends on the type of benefits you receive, whether the premiums were paid with pre-tax or after-tax dollars, and who paid the premiums.
Individual Disability Insurance
In an individual disability insurance plan, because you pay the premiums with after-tax dollars, the benefits you receive aren't taxable. Unlike health insurance premiums, however, you can't deduct premiums paid for individual disability insurance as a medical expense. Because disability insurance provides for income replacement, rather than providing for medical care, it is not a deductible medical expense.
Employer-Based Disability Insurance
In an employer-based disability insurance plan, whether the benefits you receive are taxable depends on who pays the premiums. If you pay the total premium using after-tax income, your benefits aren't taxable. But if your employer pays the total premium and doesn't include the cost of coverage in your gross income, your benefits are taxable. Following these general rules, the type of dollars used to pay the premium determines whether your benefits are taxable:
An employer-based cafeteria plan allows for employees to select coverage from a menu of options, including health, life, and disability insurance. Most often you'll pay for this coverage with pre-tax dollars. However, sometimes your employer may pay the premium for coverage you choose, up to a certain amount, and if you choose additional coverage, you may pay for the additional coverage with pre-tax or after-tax dollars. If you pay your portion of the premium with pre-tax dollars, you'll be taxed on any benefits you receive related to that portion of the premium. If you pay your portion of the premium with after-tax dollars, you generally won't be taxed on any benefits you receive related to that portion of the premium.
State Disability Insurance
Benefits received through a state disability insurance program may or may not be taxable. For example, in California, disability benefits aren't taxable, unless the benefits are in substitution for unemployment insurance. In other states, such as New York and New Jersey, disability benefits are taxable, since in those states employers pay for a part of the benefits.
If you were to begin receiving disability benefits, you should consider how your benefits would be taxed. If you use pre-tax dollars to pay your premium, your benefits will generally be taxable. On the other hand, if you use after-tax dollars to pay your premium, your benefits generally won't be taxable.
Consider Meeting with a Disability Attorney
Disability benefits are typically needed the most when we're feeling the worst. Who has the energy or wherewithal to parse complex legal terms when lying in a hospital bed or recovering from a serious injury? Even the most competent among us need professional legal advice from time to time. If you have questions about disability insurance, consider meeting with an attorney specializing in disability insurance claims.