Are disability benefits taxable or tax-free?

Q. Maybe you can settle a disagreement. My dad says his disability benefits are tax-free. I say they’re taxable. Who is right?
— Son

A. You can both be correct depending on the nature of the disability benefits.

The taxability of disability benefits typically depends on the deductibility of the premium payments and who made the payment, said Chadderdon O’Brien, a certified financial planner with RegentAtlantic in Morristown.

Let’s first look at a private disability insurance policy.

O’Brien said these premiums are typically made by an individual using after-tax dollars and are not eligible as a medical deduction on their tax return. Because the premiums were paid with after-tax dollars and the individual did not receive a deduction, when the policy begins paying benefits they will be received tax-free.

Next, consider an individual who is covered by a disability policy by their employer.

If that individual pays for the employer-provided insurance using after-tax monies, then a disability benefit would be received tax-free. However, O’Brien said, if the individual pays for premiums using pre-tax money — as in an employer sponsored cafeteria plan — then the benefit would be fully taxable.

“In the event the company makes the premiums payments on behalf of the employee and this value is not included in their gross wages, then the disability benefits received would be taxable,” O’Brien said.

It is also common that the employer will pay a portion of the premium and the employee will pay the remainder. In this situation, he said, the benefit would be partially taxed based on the portion of the premium that is paid for by the employer.

Then there are government-provided disability assistance through Social Security.

For many people, government-provided disability benefits are tax-free. If you receive benefits under the Supplemental Security Income (or SSI) program, your benefits are always tax-free, O’Brien said.

However, if you receive benefits under the Social Security Disability (or SSDI) program, a portion of your benefits may be taxable. In fact, O’Brien said, about a third of the individuals who receive benefits through the SSDI program will owe tax on a portion of their benefits. This is because their income is too high relative to IRS thresholds.

“Each year the IRS publishes base amounts which can be used to determine what portion of your benefit may be taxable,” he said. “For 2016, the base amount for married filing jointly couples is $32,000 and $25,000 for single filers.”

O’Brien said to the extent that one-half of the SSDI benefits plus all other income, including tax-exempt interest, is above the base amounts, a portion of the disability benefit will be taxable. The calculation to determine the taxability of SSDI benefits is determined using the worksheet attributed to lines 20a and 20b on your tax return.

With private policies, the type of money that is used to pay for the insurance premium (after-tax or pre-tax) is a critical distinction in the taxability of future benefits,” O’Brien said.

“If you receive a deduction for the premium payment, the benefit will likely be taxable. If you did not receive a deduction — i.e., paid for the insurance with after-tax dollars — then the benefit may be received tax-free,” he said. “With government-provided plans, your income is a key determinant as to the taxability of benefits.”

Reviewing your father’s specific situation regarding his income and disability policy with an accountant is the best way to determine how his benefits should be treated, he said.

Let us know who is the ultimate winner of your disagreement!

Karin Price Mueller writes the Bamboozled column for The Star-Ledger and she’s the founder of NJMoneyHelp.com. Click here to sign up for the NJMoneyHelp.com weekly e-newsletter. Like NJMoneyHelp.com on Facebook and follow it on Twitter.