Taxation of Disability Insurance Benefits and Premiums for University of California Employees

Research suggests that individuals approaching retirement age should be aware of the potential tax implications of disability insurance benefits. While individual disability income insurance benefits are typically tax-free because the premiums are paid with after-tax dollars, it's important to note that group disability insurance benefits may be taxable if the employer pays the entire premium and excludes it from the employee's basic income. Additionally, disability benefits received through government disability insurance programs, such as Social Security, may be subject to taxation if the recipient's total income exceeds a certain threshold. Understanding the taxation rules can help you plan your finances effectively.

What Is It?

As with all income, the disability insurance income you receive may or may not be taxable. Whether disability insurance benefits are taxable depends on the type of benefits you receive, whether the premiums were paid with pretax or after-tax dollars, and whether you or University of California paid the premiums.

Individual Disability Income Insurance

In general, the rules governing the taxation of individual disability income insurance benefits are straightforward. Because the premiums are paid with after-tax dollars, the benefits are tax-free. However, these University of California employees must remember that, unlike health insurance premiums, individual disability income insurance premiums cannot be deducted as medical expenses.

Example(s): Individual disability income insurance cost Jessie $175 per month. She began receiving disability benefits when she became incapacitated and had $15,000 in annual disability income. When filing her tax return, she was not required to include this amount as income. Neither could she deduct the $2,100 disability insurance premium she paid as a medical expense.

Caution: your employer may occasionally pay your individual insurance premium. If you are designated a key employee by the company, this may be the case. Consequently, various rules apply. Refer to the section below for details on group disability insurance.

Group Employer-Sponsored Disability Insurance

Who Pays The Premium?

If you are enlisted in an University of California-sponsored group disability insurance plan, the taxability of your benefits depends on who pays the premium. If you pay the entire premium with post-tax income, your benefits will be exempt from taxation. In contrast, if University of California pays the entire premium and does not include the cost of coverage in your basic income, then your benefits are taxable. If University of California pays a portion of your insurance premium and you pay the remainder, your tax liability will also be divided. Any portion of the benefit attributable to the portion of the premium paid by University of California is taxable. Any portion of the benefit attributable to your premium contribution is exempt from taxation.

Example(s): Phyllis was covered by her employer's group disability insurance plan. Her employer paid half the monthly premium, while Phyllis paid the other half with after-tax dollars. When Phyllis became disabled, she received a monthly benefit of $1,000 for six months. When she submitted her taxes, she was only required to pay tax on $3,000 (half of the benefit she had received), the portion attributable to her employer's contribution.

Is Your Share of The Premium Paid  with  Pretax or After-Tax Dollars?

The type of dollars you use to pay any portion of the premium for prospective University of California-sponsored disability coverage will determine whether your benefit is taxable. If you pay your portion of the premium with pretax dollars, any disability benefits you receive that are attributable to that portion of the premium will be subject to income tax. If you pay your portion of the premium with after-tax dollars, however, you will not owe income tax on any disability benefits you receive that are attributable to that portion of the premium.

How Are Benefits Paid Under Cafeteria Plans?

If University of California offers cafeteria plan benefits, you will be able to choose from a variety of employee benefits, including health, life, and disability insurance. University of California could offer an option in which they pay the premium for the benefits you select up to a certain amount, and you pay (via payroll deduction) for any additional coverage you select using either pretax or after-tax dollars. If you pay your portion of the premium with post-tax dollars, the corresponding portion of your disability benefits will be tax-free.

However, if you pay your share with pretax dollars, that portion of your disability benefits will be taxable. Therefore, if you pay a portion of your disability premium with pretax dollars, you will be required to pay income tax on all of your benefits. In contrast, if you pay your portion of the premium with after-tax dollars, you will only be taxed on the portion of the benefit that University of California is responsible for. Refer to Questions and Answers.

Example(s): Through her employer's cafeteria plan, Brenda purchased health insurance, accidental death and dismemberment insurance, and long-term disability insurance. The total monthly premium for all three benefits was $200. Brenda's monthly contribution under her employer's plan was $100 (paid in after-tax dollars) because her employer provided $100 in monthly benefits to each employee. Brenda paid tax on only 50 percent of her benefit (the portion of her benefit attributable to her employer's contribution) when she became disabled and began receiving benefits, because she had used after-tax dollars to pay her portion of the premium.

Technical Note: The number of benefits attributable to University of California's prospective contribution is determined in accordance with Section 105 of the Internal Revenue Code. If you have queries regarding the calculation of University of California's contribution, consult your tax advisor or another qualified professional.

Caution: If you are totally and permanently disabled and receive wholly or partially taxable disability benefits from University of California's-sponsored disability insurance plan, you may be able to claim a tax credit on your annual income tax return.

Group Association Disability Insurance

Association-purchased disability policies are referred to as group policies because members are offered special terms, conditions, and premiums based on the characteristics of their group. However, association policies function similarly to individual policies and have comparable tax consequences: The benefits you receive from an association policy are tax-free, and the premiums you pay are not deductible.

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Government Disability Insurance

Sometimes, Benefits Are Taxable

In general, a portion or all of the disability benefits you receive through government disability insurance programs may be taxable. The amount of the benefit that is taxable and the circumstances under which it is taxable depend on the form of government disability benefit you are receiving.

Social Security Benefits

If your only income during the year was disability income from Social Security, your benefit is typically not taxable. However, if you earned other income or had substantial investment income during the year, you may be required to pay tax on a portion of your benefit if your total income exceeds a certain threshold. The rule states that your Social Security benefit is taxable if your modified adjusted gross income plus fifty percent of your benefit exceeds the filing status's base amount.

Cole becomes disabled and begins receiving disability benefits from Social Security. Since he submits taxes as a single individual, he has a $25,000 base amount. His modified adjusted gross income (taxable income minus Social Security benefits) amounts to $20,000. He receives additional Social Security benefits of $7,000. Cole's Social Security disability benefits are exempt from taxation because his modified adjusted gross income plus half of his Social Security benefit ($20,000 plus $3,500) does not exceed his base amount.

Medicare Benefits

Medicare eligibility may be possible for disabled individuals. If you pay premiums for the Medicare medical insurance portion, you may deduct these premiums as a medical expense (as long as your total medical expenses exceed 10% of your adjusted taxable income). In addition, Medicare benefits are not subject to taxation.

Caution: 65 and older taxpayers can use the 7.5% income threshold until 2017.

Workers' Compensation

In most instances, workers' compensation disability benefits are not taxable. All benefits paid to your survivors are also exempt from taxation. In some instances, you may be able to return to work and continue receiving payments. In this scenario, your workers' compensation benefits will be taxable.

Caution: If a portion of your workers' compensation benefit reduces your Social Security benefit, that portion is regarded as a Social Security benefit. It may then be subject to Social Security taxation regulations.

Department of Veterans Affairs (VA) Benefits

The Department of Veterans Affairs (VA) disability benefits are not taxable, with the exception of certain disbursements for rehabilitative services.

Military Benefits

Most disability pensions from the military are taxable. Nevertheless, if you became disabled as a result of an injury or illness sustained during active service in any country's armed forces, your disability benefits may be exempt from taxation if any of the following conditions are met:

• On September 24, 1975, you were a member of a government service or its reserve component, or you had a binding written commitment to become a member.
• A 'combat-related injury' qualifies you for disability payments.
• You would be eligible for Department of Veterans Affairs (VA) disability compensation if you submitted an application for it.

In the absence of any of the aforementioned conditions, your disability benefit will be taxable. If only a portion of your benefit is based on a combat-related injury, only that portion will be exempt from taxation.

Federal Employees Retirement System (FERS) Benefits

If you retire on disability under FERS, your pension or annuity payments are taxable as compensation until you reach the minimum retirement age (the age at which you can begin receiving a pension or annuity if you are not disabled). Beginning the day after you attain the minimum retirement age, pension payments are taxable.

Questions & Answers

If You Have the Option of Paying for Disability Coverage With Pretax Dollars or After-Tax Dollars, Which Is Better?

When you purchase disability insurance with pretax dollars, you reduce your taxable income. This means that no taxes will be withheld from the portion of your income used to pay your disability insurance premium, as this money is not taxable. However, our University of California clients must also consider how their benefits will be taxed if they begin receiving disability benefits in the future. If you pay your insurance premium with pretax dollars, your benefit will be fully taxable because it is deemed an employer contribution. If you use after-tax dollars, however, your benefit will not be taxable. In the end, it comes down to this: If you pay your premium with pretax dollars, you will save money if you never use your disability benefits. But if you use your disability benefits, you will wind up with a lot more money if you paid your premium with after-tax dollars. Consult a tax professional for guidance.

Conclusion

Understanding the taxation of disability insurance benefits and premiums in retirement is akin to unraveling a complex puzzle in the financial realm. Imagine you are a diligent researcher analyzing different financial instruments. Each type of disability insurance represents a distinct avenue to explore, with its own tax implications. Individual disability income insurance can be likened to a meticulously planned investment strategy, offering tax-free benefits as the premiums have already been paid with after-tax funds. Group disability insurance resembles a carefully negotiated partnership, where the taxability of benefits depends on the party responsible for premium payments. Government disability insurance resembles a structured program, with certain benefits being subject to taxation based on specific circumstances. By thoroughly examining the intricacies of taxation rules, individuals can make informed decisions to optimize their retirement financial planning.