5 Things to Know About Disability Income

More than one in four (26%) of adults in the U.S. have some type of disability and this increases to two in five for adults age 65 and older. They may receive disability-related income from the government, an employer, or an insurance company. The type of income varies, and so does the tax treatment of payments received. Here are 5 things to know.

1. Social Security disability income is taxed like retirement income

Whether you receive Social Security benefits for retirement or on account of disability, the tax treatment is the same. This means that Social Security Disability Income (SSDI) may be tax free or includible in gross income at up to 50% or 85%, depending on other income.

Individuals who become eligible for SSDI may receive “back pay” in a lump sum. This covers a mandatory minimum of three to five months waiting period, but could also include payments going back months or years to the initial diagnosis. Even though the back pay relates to a prior year, it’s not reported on an amended return but on the return for the year it is received. However, there is an option on the amount of income to include:

• Use the current year’s income to figure the taxable part of the total benefits received in the current year, or
• Make an election to figure the taxable part of the lump-sum payment for an earlier year using income from that earlier year.

2. Disability means breaks related to retirement benefits

Someone under age 59½ who takes a distribution from a qualified retirement plan or IRA is not subject to the 10% early distribution penalty if he or she has a disability. A person is considered to be disabled if unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration.

A person who is named as a beneficiary of retirement benefits from someone who died after 2019 may take required minimum distributions (RMDs) over his or her life expectancy if disabled. Otherwise, all benefits generally must be received no later than the end of the 10^th year following the year of death. Under proposed regulations defining disability:

• If the designated beneficiary is under age 18 when the account owner dies, the designated beneficiary must have a “medically determinable physical or mental impairment that results in marked and severe functional limitations, and that can be expected to result in death or be of long-continued and indefinite duration.”
• If the designated beneficiary is older, then the definition of disability is the same as the one used for early distribution penalty purposes explained earlier.

The proposed regulations also have a safe harbor that uses the definition of disability for purposes of SSDI, which includes chronic illness.

3. Disability pensions may be treated as wages

If you receive disability benefits under a plan from your employer, they are treated as wages until you reach retirement age (set by the plan). This is so whether they are short-term or long-term disability payments. The payments are entered on line 1 of Form 1040 as wages, salaries, tips, etc. When you reach retirement age, if you continue to receive benefits, they are taxed like pension or annuity income.

4. Taxation of commercial disability policy benefits depends on the source of the premiums

If you paid premiums with after-tax dollars, then benefits under the policy are tax free. But if you paid premiums with pre-tax dollars, then benefits under the policy are taxed as pension or disability income. This may occur, for example, if your employer paid the premiums and this was a tax-free fringe benefit. It also results if you paid the premiums through your company’s cafeteria plan and you were not taxed on this arrangement.

5. Workers’ compensation is tax free

Benefits paid as workers’ compensation are not includible in gross income. However, if you also receive Social Security, the government benefits are reduced to the extent of workers’ comp benefits. Nonetheless, the Social Security benefit offset is still treated as having been received and taxed accordingly. This means workers’ comp benefits effectively become taxable to the extent of the Social Security benefits offset.

Conclusion

Disability income is helpful in meeting the cost of living with serious medical issues. Whether or not such income is taxable, the out-of-pocket cost of medical care can be written off as an itemized deduction (provided the 7.5%AGI floor is exceeded) if the standard deduction isn’t used. Check for further details on disability income and medical deductions.