Long-term disability insurance is one of the most valuable employee benefits offered by many employers, yet one of the most overlooked from a tax planning perspective. While most people focus on the amount of coverage provided, few consider how the benefits will be taxed if they ever need to rely on them.

Most employer-sponsored long-term disability policies replace between 50% and 70% of an employee's salary. At first glance, that may seem adequate. However, if those benefits are taxable, the actual income available to cover living expenses can be substantially less.

For example, assume a disability policy pays 70% of your pre-tax salary. If your combined federal and state income tax rate is approximately 30%, your after-tax income would be reduced to roughly 49% of your normal salary. For many individuals, particularly those in their peak earning years, that represents a significant financial hardship. While Social Security Disability Insurance (SSDI) benefits may provide additional assistance, qualifying for those benefits can be difficult and should not be relied upon as your primary plan.

The Planning Opportunity

In general, disability benefits are tax-free to the extent the insurance premiums were paid with after-tax dollars. Conversely, benefits attributable to employer-paid premiums that were excluded from the employee's taxable income are generally taxable when received.

Many employers allow employees to pay long-term disability premiums through an after-tax payroll deduction. Although this may result in a modest increase in current taxable income, it can produce a much more favorable result if disability benefits are ever needed.

Benefits Example  

Continuing the example above, assume you pay a $1,000 annual premium with after-tax dollars. If your combined federal and state income tax rate is 30%, doing so increases your current annual tax cost by approximately $300. However, if you later become disabled and receive an annual disability benefit of $105,000 (70% of a hypothetical $150,000 salary), those benefits would generally be tax-free. Had the benefits been taxable, you would have owed approximately $31,500 in income tax. In other words, an additional $300 annual tax cost today could preserve approximately $31,500 of after-tax income for each year you receive disability benefits. Even if the disability lasted only a few years, the potential tax savings could far exceed the relatively modest cost of paying the premium with after-tax dollars. 

For owners of closely held or family businesses, there may be additional planning opportunities. In some situations, the business can increase the owner's taxable compensation by the amount of the premium, allowing the owner to pay the premium with after-tax dollars. The additional tax cost is often minimal when compared to the significant advantage of receiving tax-free disability benefits during a lengthy disability. 

If both the employer and employee pay a portion of the premium, the taxation of future benefits is generally allocated proportionately. As a result, part of the benefit may be taxable while the remainder is tax-free. 

Other Important Considerations 

Many people underestimate the financial impact of a long-term disability. A disabling illness or injury is more common during an individual's working years than many realize, making disability planning an important component of a comprehensive financial plan. 

Even if disability benefits are received tax-free and adequately cover current living expenses, they may not fully protect your long-term financial security. A permanent disability can interrupt retirement savings for many years. You may lose access to employer-matching retirement plan contributions, future salary increases that would have generated additional retirement savings, continued contributions to qualified retirement plans and higher lifetime Social Security earnings. Over time, these lost opportunities can significantly reduce the assets available at retirement. 

For some individuals, purchasing a supplemental individual disability policy in addition to employer-provided coverage may help bridge this gap and provide greater financial security. 

Another important feature to evaluate is the policy's inflation or cost-of-living adjustment (COLA) rider. If a disability occurs early in your career, benefits that remain level for many years may lose significant purchasing power due to inflation. An inflation adjustment can help preserve the value of your monthly benefit over time. 

Action Steps 

To get a start on tax planning, consider these questions:  

• Who pays my disability insurance premiums? 
• Are my premiums paid with pre-tax or after-tax dollars? 
• Will my disability benefits be taxable if I become disabled? 
• Is my current benefit sufficient to support my family's needs? 
• Should I consider supplemental disability coverage or an inflation rider? 

Prepare Ahead  

A brief review today could make a substantial difference if you ever need to rely on disability benefits. If you have questions about the tax treatment of your disability coverage or would like to discuss planning opportunities, contact our individual tax pros.