Your biggest financial asset over your lifetime is not your home or your personal belongings. From a financial perspective, the most powerful asset you have is your ability to earn an income over the course of several years. Without income, it is impossible to create the life you want over time. However, many people overlook their earning ability as an asset, and because of this oversight, fail to recognize that it can be protected with the help of insurance.
Through insurance, you have the ability to transfer your risk of financial loss away from yourself and into the hands of an insurance company. In exchange for paying a premium, an insurance provider may pay for certain events that result in damage or loss.
When it comes to your earning ability, disability insurance can make a significant, positive difference in your financial picture. However, it is important to know how this type of insurance impacts your taxes, both from an insurance premium perspective and a benefits perspective.
In general, disability insurance is not tax deductible and therefore does not reduce your total taxable income when premiums are paid. However, disability insurance does have some tax benefits.
What is Disability Insurance?
In the simplest terms, disability insurance pays a portion of your salary or income if you are unable to work due to sickness or injury. Disability insurance is offered either as an employee benefit from a company or as a private, individual disability insurance policy. This type of insurance plan might be particularly important to you, for example, if you’re self-employed or a small business owner.
This coverage is beneficial in that it protects your paycheck amount, up to certain limits, and allows you to continue to pay your monthly expenses even if you are unable to work. Disability insurance premiums range significantly based on your age, gender, occupation, income, and whether you or the employer pays.
Most individuals should have some form of disability insurance coverage in place during their working years. The Social Security Administration estimates that one in every four people currently age 20 will be disabled before they reach age 67.
The most recent statistics from the Federal Reserve Board suggest that 53 percent of Americans have no emergency savings that would be sufficient in covering monthly expenses should they be out of work due to a sickness or injury. The high prevalence of disability combined with a lack of savings means disability insurance is often worth the cost.
What Part of Disability Insurance is Subject to Taxation?
Unlike health insurance premiums, which may be considered a medical expense deduction, disability insurance is not tax deductible. This means that the money you earn that is subsequently used to pay premiums on a disability insurance policy is taxed as ordinary income.
Health insurance premiums that are paid through payroll deductions are often taken out pre-tax, helping to reduce taxable income year to year. However, disability insurance premiums are paid with after-tax dollars.
What Part of Disability Insurance is Not Subject to Taxation?
While premiums paid for disability insurance policies are not tax deductible, you do have some benefit as it pertains to your taxable income when you start receiving disability insurance benefits. Once you are disabled and qualify for your benefits to be paid out, the money received is not taxed as income, according to the IRS. This is because disability insurance premiums are paid with after-tax dollars, so you have no burden to pay taxes again when you receive payments from a policy.
The fact that disability insurance premiums are tax-free is incredibly helpful if you need to go on claim. Disability income insurance payouts range from 50 percent to 80 percent of your income, depending on the insurance provider you select and the amount of coverage you put in place. This is different from life insurance, for example, which pays out a lump sum death benefit in the event of the insured person’s passing.
Because this is a smaller amount than you are used to living off of, not having an additional tax burden on top of a reduced income is helpful. The hope is that monthly obligations can still be covered while you are on disability, helping you and your loved ones avoid financial hardship.
Disability insurance is an essential component of a sound financial plan for many individuals and families. Having the right coverage in place means that you can worry less about disability due to sickness or injury in the future that would keep you from earning a steady paycheck. However, it is important to understand how disability insurance premiums are paid and how benefits are received.
You cannot take a tax deduction for disability insurance premiums paid each year, so there is no upfront tax benefit to you. The good news is that when you need the benefits the most, the payout received from your disability policy is not taxed as income. Before selecting the disability insurance coverage that’s the best fit for you and your family, consider the benefits received compared to the cost of the policy.