I was
recently reviewing an individual tax return. There was something on there that
distresses me.
This client walked
into a tax trap, and that trap has gone off. Unfortunately, there is nothing that can be
done.
Let’s talk
about disability insurance.
This client
is a personal friend. You and I would agree that he is a high-incomer. He works
for a large employer on the Kentucky side. One of the advantages of a large
employer is the benefits. One of the benefits his provides is employer-funded long-term
disability insurance.
He got hurt
and hurt badly. He is now collecting on the disability insurance, and probably
will be for a long time.
Did you know
that disability insurance can be taxable?
How?
There is
extensive tax law on the taxation of disability insurance, and there are
different answers depending upon who is paying the premiums and whether it is a
group or individual policy. There is an overarching theme, though:
Disability benefits are taxable to the extent that the
premiums were not included in income.
His
long-term insurance was 100% employer-paid and 100% excluded from W-2 income.
While this was beneficial to him then, it is the worst-case scenario now.
Long-term
policies can be expensive. Take someone who is pushing the top tax brackets, and
a recommendation to pay tax can mean thousands of extra dollars. Combine that
with an all-too-human “it cannot happen to me” response, and it is easy to understand
the reluctance.
And that is
assuming the tax advisor is even aware of what is happening. Employer-provided
disability insurance would not necessarily appear on any documents one would be
reviewing. There are good odds that you and your tax advisor will be learning
about your disability insurance together.
And so he has
to pay tax on disability at the same time that his earning power is reduced.
Is there a compromise?
I think so,
but – again – it has to be done upfront. I have no problem with short-term
disability being taxable, whether because the premiums are employer-paid or
because you run the premiums through your cafeteria plan. This is the insurance
you buy from Aflac, for example, and it pays you for six months or a year if
you get hit by the proverbial bus. Yes, it would stink to have to pay taxes,
but it would only be for a short period of time. The expectation of this
insurance is that you will heal and get back to work.
But
long-term disability is different enough to warrant a different answer. You
almost surely want to make sure this is paid with after-tax monies. If you are unfortunate
enough to collect on this type of insurance, you do not need to compound the misfortune
by having taxes as part of your household budget.
