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What are my tax obligations concerning disability benefits?

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Chances are good most people have yet to devote a single thought to Tax Day 2018 since is still nine months away. While tax considerations are not a priority right now, one's situation can change fairly quickly.

Consider what happens if you suddenly suffer a debilitating injury or illness. If the condition prevents you from working, it is possible you may need to file a long term disability claim. Depending on the circumstances, the federal government may view this as taxable income. As such, it behooves you to start keeping records of your received benefits.

All this naturally raises the question as to the tax treatment of disability benefits. The answer, actually depends upon who's paying the premiums.

Individual disability insurance

If you have secured your own disability policy, you are to be commended for your prudence. In addition to providing you with financial security, individual disability benefits are tax-free. The policyholders are paying their premiums with after-tax dollars.

It's important to note, however, premiums paid for disability insurance can't be deducted as a medical expense.

Employer-provided disability insurance

For the millions of Americans with disability insurance through employers, tax treatment is a bit different. Here, the primary inquiry is who pays the premiums? If the employee pays the premiums using after-tax income, benefits are tax-free. However, if the employer pays the premiums, benefits are taxable.

When the premium costs are split between employer and employee, so too is the tax liability. Specifically, only the benefits attributable to the employer-paid portion of the premium are taxable. Any benefits derived from the employee's portion of the premium paid with after-tax dollars are tax-free.

It's a different story if an employee uses pre-tax dollars to pay their portion of premiums. For example, if money earmarked in a medical reimbursement or cafeteria plan is used, benefits are taxable.

Source: Internal Revenue Service, "Life insurance & disability proceeds," January 30, 2017

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