Taxation of Disability Income Insurance Benefits

Who pays for disability insurance premiums (employer, employee, or a combination) and how premiums are paid (pre-tax or after-tax dollars) determine if disability insurance contributions are tax deductible and if benefit payments are taxable or tax-free.

Employer-paid insurance

Generally, if your company pays the disability insurance premiums for your employees, you can consider this a tax-deductible business expense. But any benefits paid to an employee will be taxable to the employee, thus reducing the actual benefits received. You can pay part of the premium cost with employees picking up the rest of the cost. In that case, the portion of the benefit that you pay for will be taxable to the employee and the portion paid by the employee, assuming it is paid using after-tax dollars, will be tax-free.

Employee-paid insurance

Employees who purchase coverage through your company group plan can choose to pay with pre-tax dollars or after-tax dollars. Just as with a qualified retirement plan, if premiums are paid with pre-tax money, which gives the employee an up-front tax break, then any benefits are taxable. If premiums are paid with after-tax dollars, then all benefits received are tax-free.

Game Plan

You have a lot of flexibility in how to pay disability insurance premiums for a company group plan. Picking up the cost for your employees may be seen as a valuable benefit, as well as providing a business tax deduction. But it will mean lower payouts for employees, because benefits will be taxable. Talk to your tax professional and weigh the pros and cons of covering all or part of the cost for your employees.
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