Short Term Disability: Pre or Post Tax?

Short-term disability insurance provides a financial safety net by replacing a portion of your income if an illness or injury prevents you from working. These policies are offered through employers or can be purchased privately. The taxability of short-term disability payments hinges on whether premiums were funded with pre-tax or post-tax dollars, creating two different outcomes for a person receiving benefits.

Paying Premiums with Pre-Tax Dollars

Paying for short-term disability insurance with pre-tax dollars means the premium payments are deducted from your gross earnings before taxes are calculated. This is a feature of employer-sponsored benefit programs, often administered through a Section 125 cafeteria plan. This arrangement lowers your current taxable income, as the premium is not included in the wages reported in Box 1 of your annual Form W-2.

This upfront tax advantage has a trade-off when benefits are paid. If you receive payments from a plan funded with pre-tax dollars, the entire benefit amount is considered taxable income. These benefits are subject to federal, state, and local income taxes, and the provider will report this income to you and the IRS for inclusion on your tax return.

For example, if your gross monthly pay is $5,000 and your disability premium is $50, you are only taxed on $4,950 of income for that month. This saves you a small amount of tax on the $50 premium. Should you later receive a $3,000 monthly disability benefit from this plan, the full $3,000 is taxable, and you will owe income taxes on that amount.

Paying Premiums with Post-Tax Dollars

Opting to pay short-term disability premiums with post-tax dollars involves using money that has already been subjected to income and payroll taxes. This occurs when you pay for a private policy directly or authorize a payroll deduction from your net pay. This method offers no immediate reduction in your current tax bill, as the premium is paid with funds already counted as taxable income.

The advantage of this approach becomes apparent when you need to claim benefits. If you receive disability payments from a plan where you paid the premiums with post-tax money, the benefits are received tax-free. You do not have to report these payments as income to the IRS, nor will you owe any federal income tax on the amount you receive.

By paying with post-tax dollars, you forgo a small, immediate tax break on the premium amount. In exchange, you ensure that the larger disability benefit will not be diminished by income taxes.

Tax Rules for Shared Premium Costs

When the cost of disability insurance premiums is shared between the employer and the employee, the taxability of the benefits is proportional to the percentage paid by each party. The employer’s portion is a pre-tax contribution for the employee, while the employee’s share is paid with post-tax dollars. This requires a calculation to determine the taxable portion of the benefit.

The Internal Revenue Service (IRS) uses a “three-year look-back rule” for these situations. The IRS examines the premium payments made over the three years prior to the disability claim to calculate the taxable portion of the benefits. For instance, if your employer paid 70% of the premium and you paid 30% with post-tax deductions, 70% of any disability benefit you receive would be taxable income, while the remaining 30% would be tax-free.

Imagine the total annual premium for your policy is $1,000. Your employer pays $700 (70%) and you contribute $300 (30%) via post-tax payroll deductions. If you later receive a $2,000 monthly disability benefit, $1,400 of that payment would be subject to income tax, while $600 would be tax-free. This pro-rata rule ensures that the tax outcome directly reflects the source of the premium funds.

State-Mandated Disability Plan Taxation

Some jurisdictions require employees to contribute to state-run disability insurance programs through mandatory payroll deductions. These contributions are made with post-tax dollars, meaning the money is deducted from an employee’s pay after income taxes have been calculated.

Because employee contributions are made on a post-tax basis, any short-term disability benefits received from these state-mandated plans are not subject to federal income tax. An employee receiving benefits from a state disability fund does not have to report that income on their federal tax return.

While these benefits are free from federal income tax, the rules for state income tax can differ. The taxability of the benefits at the state level depends on the specific laws of that jurisdiction. Individuals receiving payments from a state disability plan should verify the specific state tax requirements.