Effective financial planning includes preparing for the worst. An emergency savings account, a fully funded retirement account, disability insurance, long-term care insurance and tax planning are essential parts of a robust financial plan. Tax treatment of disability income varies depending on the circumstances.
Private Disability Benefits
Whether your disability benefits are taxable depends on who paid for your disability insurance premiums. If you had the foresight, income and fiscal discipline to pay for private disability insurance out of pocket, the disability benefits you receive from that private policy are not taxable income. Government benefits, such as SSI, Social Security disability and military disability benefits, also are not taxable. However, if your employer paid your disability insurance premiums, the IRS considers those benefits as part of your salary or wages, so the benefits you receive from the employer-paid policy are taxable as earned income.
In some circumstances, both you and your employer may have paid disability insurance premium payments for the same policy. Where your premium payments are mixed, your disability benefits, for tax purposes, are also mixed between taxable and nontaxable income. The insurer will report the taxable portion of your premiums to the IRS as income and send you a statement for your records.
Disability Withdrawals from Retirement Accounts
The general rule for retirement account withdrawals is that the account holder must wait until she reaches retirement age before she withdraws retirement funds. Early withdrawals are subject to ordinary income tax plus, in most circumstances, a penalty equal to 10 percent of withdrawals. An exception to the rule enables an account holder who becomes disabled before she reaches retirement age to withdraw retirement funds without incurring the penalty, although she must still pay ordinary income tax on the funds. The IRS treats these withdrawals as earned income, not pension income, so the account holder remains eligible for the earned income credit, a tax credit for taxpayers whose earned income is relatively low.
There are steps you can take to help ensure that you don't pay more tax than you need to on your disability income. In most cases, you can request that your insurer withhold income tax from your benefits, similar to the way your employer would be withholding taxes from your wages if you were still employed. You can also make quarterly tax payments on your taxable disability income. Prepaying a portion of your taxes helps you avoid late fees, interest and penalties if you can't pay your taxes when they're due.
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