Is State Disability Income Taxable on Federal Taxes?

The federal taxability of income from a state-sponsored disability plan depends on who paid the premiums for the coverage. State disability income is a benefit paid to individuals who are temporarily unable to work due to a non-work-related illness or injury. Understanding the source of the premium payments is the first step to determine if you will owe federal taxes.

The Premium Payment Rule for Taxation

The Internal Revenue Service (IRS) standard for determining if disability benefits are taxable centers on whether premiums were paid with pre-tax or after-tax dollars. If you, the employee, paid the premiums for the disability plan using your own after-tax money, the benefits you receive are not subject to federal income tax. This is a common arrangement for mandatory state disability programs where deductions are taken from your paycheck.

If your employer pays the full cost of the disability insurance premiums and does not include that amount as part of your taxable income, the disability benefits you receive are fully taxable. These employer-paid benefits are treated as a replacement for wages and are considered taxable income.

If both you and your employer contribute to the plan’s premiums, the taxability of the benefits is proportional to the premium contributions. For example, if your employer paid 70% of the premium and you paid 30% with after-tax dollars, then 70% of the benefit is federally taxable. You can examine your pay stubs for deductions, often labeled as SDI or TDI, to see employee contributions.

Tax Treatment of Mandatory State Plans

Several jurisdictions require employees to participate in a state-run disability insurance program. These include:

• California
• Hawaii
• New Jersey
• New York
• Rhode Island
• The U.S. territory of Puerto Rico

These programs are funded through mandatory employee payroll deductions using after-tax dollars. Because the employee pays their share of the premium, the benefits from these state funds are not taxable on your federal return.

This non-taxable treatment applies only to benefits from the state-administered fund. It is important to distinguish these from any supplemental short-term disability plans from your employer. If your employer offers a separate, private disability policy and pays the premiums, any benefits from that policy would be taxable.

An exception can occur if state disability benefits are received as a substitute for unemployment insurance (UI). If you were receiving taxable UI benefits, then became disabled and started receiving state disability benefits, the disability payments are considered a replacement for unemployment and become federally taxable. You may receive a Form 1099-G indicating the taxable amount.

How to Report Disability Income for Federal Taxes

If you have determined that your benefits are taxable because your employer paid the premiums, the income is reported to you on Form W-2, Wage and Tax Statement. The payer of the benefits, which could be your employer or an insurance company, is responsible for issuing this form.

This income is included in the wages reported in Box 1 of your Form W-2, and you must report this amount as wages on your Form 1040. The income is subject to the same federal income tax withholding rules as regular wages. You can request to have federal income tax withheld by filing Form W-4S, Request for Federal Income Tax Withholding From Sick Pay, with the payer of your benefits.

If your disability benefits are not taxable, do not report them as income on your federal tax return. You might still receive an informational statement from the state, like a Form 1099-G, but you are not required to report the amount if it qualifies as non-taxable. The form may be issued because a portion of the benefits could be taxable under certain circumstances.