Most Social Security disability claimants wait several months – and sometimes several years – before they are approved for benefits. When you are approved for benefits, you will generally be awarded a retroactive payment, or back pay, of all the benefits you should have received from the date of onset of your disability. In many – but not all – cases, these retroactive Social Security benefits are taxable.
When you receive an SSDI back pay lump sum for retroactive benefits, you may be surprised to learn that you are likely responsible for paying taxes on these benefits.
Taxable Disability Benefits
Supplemental Security Income (SSI) is needs based. If your income and resources are low enough to qualify for SSI, then you are exempt from income tax by definition.
However, up to 85 percent of Social Security Disability Insurance (SSDI) payments are taxable. The percentage that is taxable is based on your total "provisional income." Provisional income includes half of your income from Social Security and all other income.
For example, if you received $12,000 from Social Security and $5,000 from another source last year, your total provisional income was $11,000 ( $12,000/2 + $5,000). IRS Publication 915 gives instructions on how to determine your provisional income and the percentage of your benefits that are liable to taxation.
Reporting Back Pay
You have two choices for reporting Social Security back pay on your taxes. One is to report the back pay as income in the year in which you received it. If you do this, the taxable portion of your benefits will all be taxed using that year's rate. The other option – called lump sum election – allows you to determine your tax rate on the lump sum payment as if you had been receiving the benefits from the time you were disabled.
The advantage of choosing a lump sum payment tax is that you are able to factor in all of your deductions for every year in which you should have received benefits.
Calculating Lump Sum Payment Tax
Calculating taxes using the lump sum election involves recalculating your tax returns from previous years. Your 1099 from the SSA will include a breakdown of how much Social Security income can be attributed to each year.
Calculate the amount of tax you would have paid each year if you received the benefit amount indicated on your 1099, then subtract the amounts you actually paid in those years. Add or subtract this result to your current tax return to determine your tax liability. For example, if you would have owed $1,000 in taxes last year if you had been receiving benefits, but actually paid $800 in taxes last year, you will need to add the $200 liability to your current tax return.
Other Tax Considerations
If you incurred legitimate expenses in obtaining your Social Security disability benefits, you can itemize and deduct them on your tax return. The most common expenses associated with obtaining disability benefits are lawyers' fees.
Social Security lawyers' fees are often handled by the SSA directly and subtracted from claimants' back pay. If you paid lawyer's fees – whether the SSA subtracted them from your back pay or you paid the lawyer directly – you may deduct a percentage of those expenses equal to the percentage of your Social Security benefits that are taxable.
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