381 / How are benefits provided under an employer-provided disability income plan taxed?

Sick pay, wage continuation payments, and disability income payments, both preretirement and postretirement, generally are fully includable in gross income and taxable to an employee.¹ Specifically, long-term disability income payments received under a policy paid for by an employer are fully includable in income to a taxpayer.²

A disabled former employee could not exclude from income a lump sum payment received from the insurance company that provided the employee’s employer-paid long-term disability coverage. The lump sum nature of the settlement did not change the nature of the payment into something other than a payment received under accident or health insurance.³

If benefits are received under a plan to which an employee has contributed, the portion of the disability income attributable to the employee’s contributions is tax-free.⁴ Under an individual policy, an employee’s contributions for the current policy year are taken into consideration. With a group policy, an employee’s contributions for the last three years, if known, are considered.⁵

In Revenue Ruling 2004-55, the IRS held that the three-year look back rule did not apply because the plan was amended so that, with respect to each employee, the amended plan was financed either solely by the employer or solely by the employee. The three-year look back rule does not apply if a plan is not considered a contributory plan.

An employer may allow employees to elect, on an annual basis, whether to have premiums for a group disability income policy included in employees’ income for that year. An employee who elects to have premiums included in his or her income will not be taxed on benefits received during a period of disability beginning in that tax year.⁶ An employee’s election will be effective for each tax year without regard to employer and employee contributions for prior years.

Where an employee-owner reimbursed his corporation for payment of premiums on a disability income policy, the benefit payments that he received while disabled were excludable from income under IRC Section 104(a)(3).⁷

Where an employer initially paid disability income insurance premiums but, prior to a second period of benefit payments, an employee took responsibility for paying premiums personally, the benefits paid from the disability income policy during the second benefit-paying period were not includable in the employee’s income.⁸

Premiums paid by a former employee under an earlier long-term disability plan were not considered paid toward a later plan from which the employee received benefit payments. Thus, disability benefits were includable in income.⁹ If an employer merely withholds employee contributions and makes none itself, the payments are excludable.¹⁰ A tax credit for disability retirement income is available to taxpayers receiving those payments after the minimum age at which they would have received a pension or annuity if not disabled. This credit is called the Disability and Earned Income Tax Credit (EITC).