Taxes on short-term disability benefits are determined by the method of coverage and the reporting of coverage as per the U.S. IRS Revenue Rule 2004-55.(1) For example, for employer provided disability insurance coverage, the cost of coverage can be either reported as income or not. In the latter case, the benefits received in the instance of disability benefits may be taxable whereas the reverse may be the case for the former. Short term disability benefits are reported on lines 20 and 21 of the 2009 IRS Form 1040. To avoid taxes on short-term disability benefits the following actions may be helpful:
1. Complete an IRS Form W4-V for Voluntary withholding of coverage premiums.
2. Pay for disability coverage privately.
3. Earn under the income cap limit for Social Security Disability Benefits.
To illustrate more specifically, pre-tax and after-tax income received from short-term disability benefits may be taxable for the individual in the former case and non-taxable in the latter. The reason for the difference in taxation is the manner in which the benefits are handled. In the former case, the employer does not pay taxes on the benefits for the employee but in that latter case it does.
These stipulations are illustrated by U.S. Internal Revenue Service (IRS) Revenue Ruling 2004-55 which according to Mellon Financial Corporation applies to all tax payers.(4) The ruling represents a means by which short-term disability benefits may not be taxable. However, as mentioned previously, the original disability coverage must be reported as income for any future benefits to be tax free. In the case of partial contributions being reported, a partial tax break may be incurred according to a Mutual of Omaha benefits claim procedure guide.(3)
Types of short-term disability benefits
The type of short-term disability, timing of coverage and sources of coverage financing can also influence taxation of benefits. For example, benefits from privately financed disability insurance is not taxable as per the aforementioned revenue bulletin. Some of the different scenarios in which benefits may be received are listed below. Each of these scenarios have potentially taxable or non-taxable benefits.
(1) Short-term disability from social security: Subject to income caps, and specific reductions.
(2) Private short-term disability coverage: If paid for by recipient, benefits are non-taxable.
(3) Employer short-term disability coverage: If paid for by employer but not reported as income by employee, taxable benefits. If partially paid for by employee, partially taxable benefits.
Useful IRS forms and publications for disability benefits
Benefits from short-term disability coverage should be reported to the IRS because it is still considered income regardless of whether or not it is taxable. There are spaces for both the taxable and non-taxable amounts in IRS Form 1040. Other forms that may be needed are Social Security Statements or 1099 summaries, voluntary withholding forms and income forms in which benefits are included in income.
• IRS Publication 915: Social Security information
• SSA-1099: Social Security income statement
• Form W-4V: Voluntary tax withholding form
• IRS Form 1040: Standard tax reporting form
• IRS Form 1040 Instructions
• IRS Publication 525: Income tax information
• Form W-2: Employer income statement
The scenarios in which these forms and publications are used vary. IRS Publication 915 covers Social Security benefit reporting whereas the 1040 instructions have information for non Social Security benefit reporting. Other forms such as the W-2 are forms received by employers that indicate income received, which in some cases, can include disability benefits paid through an employers insurance provider.
Short term disability coverage may or may not be taxable depending on the method and means by which the insurance is provided, paid for and reported. Income is also a factor in the case of Social Security disability benefits. By not including disability coverage from an employer as income, one is taking the chance disability income will not be received. This is a decision to be made by the coverage recipient and may be assisted via a personal risk assessment or employment risks audit. The forms, sources and publications cited in this article may be of additional assistance in determining whether disability benefits will be taxed, and how to reduce or eliminate the amount of disability pension taxed.
1. http://www.irs.gov/irb/2004-26_IRB/ar06.html (IRS Bulletin 2004-26: Revenue Rule 2004-55)