Disability income policies offer some income tax advantages. In summary, although individuals who pay premiums for individually-owned disability income policies generally may not deduct the premium payments from income for income tax purposes, disability income benefit payments received from personally-purchased policies are exempt from income taxation.
1. Disability Income Premium Payments
Generally, premiums paid by an individual for an individually owned disability income policy are not considered premiums paid for medical care and, thus, are not deductible from income for income tax purposes.
In contrast, premiums paid by an employer for disability income policies provided to employees are deductible to the employer in the year paid. This deduction is available for both individual disability income policies and group disability income policies. The reason why the rules permit employers to deduct the premiums they pay for their employees’ disability coverage is that these payments are treated as part of the employees’ compensation. However, this deduction for disability income premiums is available to the employer only if the benefits are payable to employees or their beneficiaries. It cannot be taken if the disability benefits are payable to the employer.
2. Disability Income Benefit Payments
Generally, disability income benefits from personally- purchased policies are exempt from income tax. Further, there is no limit on the amount of disability income benefits that insureds can receive tax-free under personally-owned disability income policies.
On the other hand, employee-insureds must fully include in their gross income and pay tax on the disability income payments they receive from disability income policies on which their employers have paid the premiums. If employees receive benefits under a plan for which they have contributed some of the cost, the employees will receive the portion of the disability income attributable to the employees’ contributions income-tax free. But if employees choose in advance to reimburse their employers for premiums their employers pay on disability income policies, the employees are entitled to exclude any benefit payments that they receive while disabled from their reportable income.
If the employer and employee share the cost of the disability income insurance, only that portion of the disability income benefits attributable to the employer’s premium payments is includable in the employee’s income.
Example. Suppose the employee pays one-third of the premium and his employer pays the remaining two-thirds of the premiums. If the employee becomes disabled, one-third of the benefits received from the policy will be tax-exempt and two-thirds of the disability income benefit will be taxable.
If the employer pays all the premiums but they are not excludable from the employee’s gross income in the year the employer pays them, any disability income benefits the employee-insured may receive will be tax-exempt.
Where benefit amounts are determined by other methods, the income taxation of benefit payments may differ. For example, benefits from a plan for injured football players where the benefit amount was determined by the number of seasons played rather than the type and severity of the injury as required were not excludable from income. Furthermore, benefits determined as a percentage of disabled employees’ salaries, rather than being based on the nature of their injuries, typically are not excludable from income.
3. Tax Credit for the Elderly and the Permanently and Totally Disabled
Section 22 of the Internal Revenue Code offers an income tax credit to qualified individuals who were totally disabled when they retired. The amount of the credit is 15 percent of the taxpayer’s section 22 amount. Disability income is defined as the taxable amount individuals receive under their employers’ plans as wages or payments in place of wages for the period they are absent from work due to disability.
Qualified individuals are those who are age sixty-five or older or who are under age sixty-five, retired on disability, and considered permanently and totally disabled. Permanent and total disability is the inability “to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which qualified doctors can expect to result in death or which has lasted or doctors reasonably can expect to last for a continuous period of not less than twelve months.”
To determine the amount of the credit, individuals must determine their Section 22 amount for the taxable year. The credit equals 15 percent of that amount; however, because it is a nonrefundable credit, it may not exceed the taxpayer’s income tax liability for the taxable year.
The base Section 22 amount is $5,000 for a single taxpayer or married taxpayers filing jointly if only one spouse qualifies for the credit; $7,500 for married taxpayers filing jointly if both qualify; and $3,750 for married taxpayers filing separately. The base figure (or the amount of disability income in the case of individuals under age sixty-five if that is less) is reduced dollar-for-dollar by one-half of adjusted gross income in excess of $7,500 (single taxpayer); $10,000 (joint return); or $5,000 (married filing separately).
4. Gift, Estate, and Generation-Skipping Transfer Taxation
Basically, disability income premiums or benefit payments are not affected in any special way by the gift tax, the estate tax, and the generation-skipping transfer tax. An individual can make a gift of any amount of cash that the recipient will use to pay disability income premiums. Such a gift would be considered a present interest gift and, as such, would qualify for the gift tax annual exclusion of $14,000 in 2015. Because insurers only pay disability income benefits during the insured’s life, after his or her death, nothing remains to be transferred to an heir or beneficiary.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM