Is Long-Term Disability Considered Earned Income for Taxes?

Long-term disability benefits provide financial relief when an individual cannot work due to illness or injury. Understanding their tax classification is essential, as it determines whether they are subject to income tax and how they should be reported.

Tax treatment depends on who paid the premiums and whether they were funded with pre-tax or after-tax dollars.

Differences Between Earned and Unearned Income

The IRS classifies income as either earned or unearned. Earned income comes from active work, while unearned income stems from investments or benefits. This distinction affects tax obligations and eligibility for certain credits.

Wages and Salaries

Earned income includes wages, salaries, and bonuses from employment. Employers withhold federal and state income taxes, as well as Social Security and Medicare taxes.

For example, an employee earning $50,000 annually has federal income tax withheld based on a progressive rate ranging from 10% to 37% in 2024. Social Security tax is 6.2% on earnings up to $168,600, and Medicare tax is 1.45%, with an additional 0.9% surtax on wages exceeding $200,000 for single filers. These deductions distinguish wages from income sources that do not require active work.

Self-Employment Income

Self-employed individuals, such as freelancers and business owners, are responsible for their own tax payments. Unlike employees, they do not have taxes withheld by an employer and must pay self-employment tax, which covers Social Security and Medicare. This tax totals 15.3% of net earnings—12.4% for Social Security (up to the wage base limit) and 2.9% for Medicare.

A freelance graphic designer earning $80,000 annually must pay both income tax and self-employment tax. However, they can deduct half of the self-employment tax from their adjusted gross income (AGI) and claim business expenses such as office supplies, software, and travel costs to reduce taxable income. They must also make quarterly estimated tax payments to avoid penalties.

Passive Revenue

Passive income comes from investments or ventures that do not require active involvement, such as rental income, dividends, interest, royalties, and capital gains. These earnings are taxed differently from wages and self-employment income, often at lower rates.

Qualified dividends and long-term capital gains are taxed at 0%, 15%, or 20%, depending on taxable income. Rental income is reported on Schedule E of Form 1040, and landlords can deduct expenses like mortgage interest, property management fees, and depreciation. Interest from savings accounts and bond yields is taxed at ordinary income rates unless it comes from tax-exempt municipal bonds. Unlike earned income, passive revenue is not subject to Social Security or Medicare taxes.

Tax Classification of Long-Term Disability Payments

The taxability of long-term disability benefits depends on how the insurance premiums were funded. If an employer pays for the policy and does not include the premium cost in the employee’s taxable wages, the benefits are taxable. These payments are reported on Form W-2, and recipients can opt for tax withholding.

If an individual pays the premiums entirely with after-tax dollars, the benefits are tax-free. Since the premiums were paid with taxed income, the IRS does not impose additional tax on the benefits. Many private disability insurance policies follow this structure, allowing recipients to receive full payments without tax deductions.

For policies with shared premium costs, the taxable portion corresponds to the employer-paid share. If an employer covers 60% of the premium and the employee pays 40% with after-tax dollars, then 60% of the benefits are taxable, while 40% remain tax-free.

Social Security Disability Insurance (SSDI) benefits may be taxable depending on total household income. If half of the SSDI benefits plus other income exceeds $25,000 for single filers or $32,000 for joint filers, a portion of the benefits—ranging from 50% to 85%—becomes taxable. Supplemental Security Income (SSI), a need-based program, is never taxable.

Documentation for Filing Taxes

Proper documentation is essential when reporting long-term disability benefits. Individuals receiving taxable benefits through an employer-sponsored plan will typically receive Form W-2, which details the amount received and any taxes withheld. This form should be reviewed for accuracy before filing.

For those with private disability insurance paid with after-tax dollars, policy statements and payment records should be kept to verify that benefits are non-taxable. While these payments do not need to be reported on a tax return, maintaining records can help in case of an IRS inquiry.

SSDI recipients receive Form SSA-1099, which outlines total benefits paid during the year. If a portion of these benefits is taxable, the form helps determine the reportable amount. Taxpayers with additional income sources may need to use the worksheet in IRS Publication 915 to calculate the taxable portion.