The answer to so many questions in life is, “it depends,” and whether your disability benefits are taxable is no exception. The answer depends on which kind of disability benefits you receive, who pays for the benefits, and how the benefits are paid. As a general rule, if you depend solely on Social Security checks for income, you probably won’t be paying tax on any benefits you receive. Think taxation on your Social Security benefits does not apply to you? Think again: according to the Council for Disability Awareness, 1 in 4 people age 20 today will lose at least one year of work before they reach retirement age because of a disabling condition.
First, a distinction must be made between Social Security retirement benefits and Social Security Disability benefits. Social Security retirement benefits are awarded when an individual reaches retirement age, regardless of whether he or she actually retires from work. Federal income tax will be assessed on Social Security benefits if the individual has substantial income from other sources, such as a 401(k) plan, wages, interest, or dividends.
According to the IRS, “income” means adjusted gross income plus any nontaxable interest income plus half of your Social Security benefits, and income can include pension payments, disability benefits, survivor benefits, and monthly retirement benefits. If you have reached retirement age and do have substantial income outside of your Social Security benefits, the portion of your benefits that will be subject to taxation will vary with your income level.
There are generally three types of disability income that will determine whether the disability benefits you receive are taxable. The first type is Social Security Disability Insurance (SSDI), which is funded by payroll taxes that are withheld from employee paychecks or taxes that are paid out of self-employment taxes. The second type is Supplemental Security Income (SSI) that is reserved for disabled adults and children and adults over age 65 that have limited income and resources. The third type is private disability insurance benefits, which is paid for through an employer-sponsored policy or a policy that an individual purchases; disability insurance policies can be long- or short-term and are designed to pay a portion of your salary if you become disabled.
The eligibility criteria for SSDI and SSI based on a disability is the same. You must suffer from a medically determinable mental or physical impairment that is expected to last continuously for at least 12 months or result in your death that keeps you from engaging in any substantial activity.
SSI benefits are not taxable. Because the benefits are needs-based and awarded to people with low or no income who have minimal, if any, assets and who, by definition, have insufficient income to meet the threshold for taxation, SSI benefits are not taxed. Similarly, if you have a child who receives dependent or survivor Social Security benefits, that amount does not count toward taxable income.
SSDI benefits are taxed federally the same way Social Security retirement benefits are taxed, as explained above. For benefits received through a long- or short-term disability policy, the taxes assessed depends on who paid for the policy. If your employer paid the premiums on your policy, any disability income received is taxable to you. If you paid the premiums, then the taxes are determined based on whether you paid the premiums with pretax or post-tax dollars. If you paid the premiums with pretax dollars, you have not yet paid taxes on those monies, so you will be taxed when you receive the benefits. In contrast, if you paid the premiums with post-tax dollars, the tax has already been paid as you paid into the policy; therefore, taxes will not be assessed when you start receiving benefits. If you and your employer split payment of the premiums, some of the benefits will be taxed but not all.
If you do have to pay taxes on your Social Security benefits, whether they are retirement benefits, SSDI benefits, or private disability insurance benefits, you can make quarterly estimated tax payments to the IRS or have federal taxes withheld from your benefits before you receive them. When it comes time to file your taxes, you can use the Social Security Benefit Statement (Form SSA-1099) to show you the benefit amount that you received the previous year and help you file your income tax return.
For SSDI tax withholdings, you can ask the Social Security Administration to withhold taxes when you apply for disability benefits initially. Alternatively, you can complete Form W-4V and select a withholding rate of 7%, 10%, 12%, or 22%. If you receive disability benefits from an insurance company through a private long- or short-term disability policy, you can ask the insurance company to withhold taxes on your benefits by filling out Form W-4S.
In the event that you receive a lump-sum benefit payment for back pay, do not worry that the large payment will bump you into a different tax bracket. The IRS will allow you to go back and amend previous years’ tax returns up until the relevant year for which the back pay was designated to compensate you.
Please keep in mind that the above only considers federal tax on your Social Security benefits. It is possible that the state you live in will also assess taxes on the benefits you receive. Minnesota, North Dakota, Vermont, and West Virginia tax your Social Security benefits the same way the federal government does. Partial taxes on your Social Security benefits are levied in Colorado, Connecticut, Kansas, Missouri, Montana, Nebraska, New Mexico, Rhode Island, and Utah.