The purpose of disability insurance is to provide a continuing source of income to a disabled worker. Although the replacement income is typically less than the earlier earned wages, it is sometimes completely nontaxable. In other situations where it is taxable, there is a possibility to utilize the payments to qualify for the earned income tax credit.
The general rule
Disability coverage is often part of a health or accident insurance plan. Whether disability income is taxable or not depends largely on who paid the insurance premiums. If your employer paid the full cost of the premiums, your disability income is fully taxable. If you voluntarily purchased insurance on your own and paid all the premiums yourself, disability income is not taxable.
The effect of pre-tax premium payments
Many employers offer a benefits option to employees referred to as a cafeteria plan. The plan allows employees to use a portion of their wages to pay for disability insurance on a pre-tax basis. By choosing the pre-tax option, income tax is never paid on that portion that you allocate to pay premiums. Consequently, any later disability income resulting from pre-tax premiums is taxable.
The earned income credit
Although nontaxable income is usually preferable to taxable income, an exception applies to disability income. The earned income credit is based on earned income, and taxable disability payments are sometimes considered to be the equivalent of earned income. The availability of the credit depends on whether taxable disability payments are categorized as wages or pension income.
You may need to consult with your employer if you are not certain of your company's minimum retirement age. Until you reach the minimum retirement age for your company, disability income is reported as wages, eligible for the earned income credit. After you reach the company's minimum retirement age, disability income is reported as pension income.
Preparation of Form 1040
Pension income does not qualify for the earned income credit. There is a specific line on IRS Form 1040 for wages, and another specific line for pensions. Taxable disability income is entered on the appropriate line, and the earned income credit is calculated if applicable. Nontaxable disability income is not reported.
Most disability insurance commitments end at age 65, but the distinction between wages and pension income can make a significant difference in the preceding years. Contact a tax preparation specialist like Tri Check Inc for further information about disability income or any other aspect of income tax preparation.