Do I Claim Short-Term Disability on Taxes?

Short-term disability is a type of insurance benefit providing a portion of an individual’s income when they are temporarily unable to work due to illness or injury. This benefit serves as a financial bridge, replacing a percentage of lost wages during a period of recovery or incapacitation. This article aims to clarify the tax treatment of short-term disability payments.

Understanding Taxable Short-Term Disability Payments

The taxability of short-term disability payments depends on who paid the premiums for the disability insurance policy and whether those premiums were paid with pre-tax or after-tax dollars. When an employer pays 100% of the short-term disability insurance premiums, the full amount of benefits an employee receives is taxable income. This is because employer premium contributions are not included in the employee’s gross income when initially paid, making the benefits taxable when received.

If an employee pays the premiums for their short-term disability coverage using pre-tax dollars, such as through a cafeteria plan under Internal Revenue Code (IRC) Section 125, the benefits received are also taxable. In this arrangement, premium payments reduce the employee’s taxable gross income. Since the employee avoided paying income tax on the money used for premiums, the benefits are subject to taxation upon receipt.

Conversely, if an employee pays the premiums with after-tax dollars, the benefits received are not subject to income tax. This means the employee used funds that had already been taxed to pay for the insurance. Because taxes were already paid on the money used to purchase the coverage, the benefits are considered a return of capital and are not taxed again.

When both the employer and employee contribute to short-term disability insurance premiums, a hybrid tax treatment applies. Only the portion of the benefit attributable to employer contributions or employee pre-tax contributions is taxable. For example, if an employer paid 60% of the premiums and the employee paid 40% with after-tax dollars, then 60% of the disability benefit would be taxable income.

Reporting Short-Term Disability Income on Your Tax Return

The method for reporting short-term disability income depends on how payments were issued and the type of form received. This income is typically reported on either a Form W-2, Wage and Tax Statement; a Form 1099-MISC, Miscellaneous Information; or a Form 1099-G, Certain Government Payments. The specific form indicates how the income should be entered on Form 1040.

If short-term disability payments are made directly by an employer as part of their regular payroll, these amounts may be included on Form W-2. Taxable disability payments might appear in Box 1, “Wages, tips, other compensation,” or could be reported in Box 12 with a specific code, such as “J” for sick pay not includible as wages. Additionally, if the payments are subject to Social Security and Medicare taxes, they would be included in Box 3, “Social Security wages,” and Box 5, “Medicare wages and tips.” These amounts are then reported on the “Wages, salaries, tips, etc.” line of Form 1040.

When a third-party insurer issues short-term disability benefits, the income is reported on Form 1099-MISC. Taxable disability payments are found in Box 3, “Other income.” This income is reported on Schedule 1 (Form 1040), Additional Income and Adjustments to Income, under the “Other income” section.

State-paid disability benefits, such as those from state-mandated programs, are reported on Form 1099-G. The taxable amount is shown in Box 1, “Unemployment compensation.” This income is reported on Schedule 1 (Form 1040) on the line designated for unemployment compensation or as other income.

Specific Scenarios and Additional Considerations

State Disability Insurance (SDI) benefits, mandated in some states like California, New Jersey, and New York, are reported on Form 1099-G. These benefits are taxable income for federal purposes. The tax treatment of SDI benefits often mirrors that of unemployment compensation, meaning they are included in an individual’s gross income.

Short-term disability benefits can interact with other income replacement, such as Workers’ Compensation or Social Security Disability Insurance (SSDI) benefits. Workers’ Compensation benefits, paid for injuries or illnesses sustained on the job, are exempt from federal income tax under Internal Revenue Code Section 104. Social Security Disability Insurance benefits, however, may be partially taxable depending on the recipient’s total income, as outlined in Section 86. While receiving one benefit might reduce the amount of another, their individual tax treatments remain distinct.

Tax withholding from short-term disability payments can vary depending on the payer, whether it is an employer, a third-party insurer, or a state agency. Some payers may not withhold income tax from these payments, which can lead to an unexpected tax liability at the end of the year. Recipients should review their benefit statements to determine if taxes are being withheld. If adequate taxes are not being withheld, individuals may need to make estimated tax payments throughout the year using Form 1040-ES to avoid underpayment penalties under Section 6654.

Taxable short-term disability income contributes to an individual’s Adjusted Gross Income (AGI). An increase in AGI can influence eligibility for tax credits and deductions, which often have income phase-out thresholds. For instance, a higher AGI might reduce a refundable tax credit or make an individual ineligible for specific itemized deductions.