Structure Disability Benefits to be Tax-Free

Many employers provide long-term disability benefits to employees. It’s a great benefit, but no one considers the tax side. Typical policy benefits pay the equivalent of 50%-70% of the normal salary. That could be adequate if the benefits are not taxable. If they are taxable, you’ll wind up with significantly less income. For example, let’s say the disability benefit is 70% of the current pre-tax salary. If combined federal and state taxes are 30%, your after-tax home will be approximately 49% of normal salary. That’s a significant pay cut, particularly for someone in the prime of their career. Now, that difference could be made up by Social Security Disability Insurance (SSI) – if you qualify. 

The Solution 

If your disability premiums are paid with after-tax dollars (paid by you), the benefits are tax-free. The company can continue to pay for you, but it’s a payroll deduction rather than a tax-free benefit. In the case of a family or closely held business, the company could raise your salary by the amount of the premium and then pay on your behalf. The only downside is the small amount of additional tax you’ll pay on the premiums, which is nominal considering the potential benefit. 

What happens if you pay part of the premiums, and the employer pays the remainder? Then, the tax treatment is split. 

Other Considerations 

Most people don’t consider the chance of disability to be higher than death. At age 50, the likelihood of long-term disability is 5 in 22 for an average duration of 50 months.

Even if the disability payments are tax-free and handle current living expenses, that may not be enough in the long term. If you become fully and permanently disabled, you will not have access to a retirement plan or, more importantly, any company match. You’ll also forgo pay raises that would have produced additional retirement savings and benefits. This means at full retirement, your nest egg will be significantly less than if you had continued to work. One solution is to purchase a supplemental policy in addition to your employer’s benefits. 

Inflation riders vary. Becoming permanently disabled at a relatively young age makes the inflation adjustment very important. If you’re in your 60s, that may be a minor consideration.   

There is no time like the present to check benefits and tax treatment for long-term disability.