Taxes Owed on LTD Benefits Depend on Who Pays Premiums, and How
If we pay the premium for employees’ long-term disability (LTD) benefits and they need to use LTD one day, would they owe taxes on the amount they receive?
There are two main types of LTD plans. The first is considered a Group Long-Term Disability Plan (Group LTD). A Group LTD is generally employer-sponsored and covers all eligible employees. You may choose to pay part or all of the premiums for the Group LTD.
Another type of LTD is called an Individual Disability Insurance Policy (IDI). An employee traditionally purchases an IDI policy through an insurance agent, not the employer.
Some employees opt to combine coverage, supplementing the employer-sponsored Group LTD with an IDI policy. Finally, some professional associations offer LTD plans. Examples include AMA- and ADA-sponsored policies available to physicians and dentists.
Every LTD has premiums that someone must pay. The payment for the premiums comes from either pre-tax dollars or post-tax dollars. Pre-tax dollars means income before any deductions for federal, state, and withholding taxes have occurred. Post-tax dollars means income after federal, state, and withholding taxes have been deducted. Whether the premium is paid from pre-tax or post-tax dollars determines the taxation of the LTD benefits.
If you pay 100 percent of the premium, 100 percent of the LTD benefit is taxable to the employee. If you pay only a portion of the premium and the employee pays the balance with post-tax dollars, then the LTD benefits are taxable in the same proportion as the percentage of the premium you paid. If you pay only a portion of the premium and the employee pays the remainder with pre-tax dollars through a Section 125 Cafeteria Plan, then the LTD benefits received are 100 percent taxable to the employee.
If you don’t contribute to the premiums and the employee pays the entire premium with post-tax dollars, then the LTD benefits received aren’t taxable. If the employee pays the entire premium with pre-tax dollars and you don’t contribute to the premiums, then the benefits received are 100 percent taxable to the employee.
Under tax regulations, if you pay a percentage of the premium, the percentage is calculated using a three-year average. For a Group LTD policy in force for three or more years, the three-year average equals the three policy years before the calendar year in which the benefits were paid. If the Group LTD is in place for less than three years but more than one year, then the percentage of the premium you pay is based on the actual premiums paid. For a Group LTD policy in place for less than one year, you can use a reasonable estimate of the percentage of the premiums you pay.
To calculate the taxable benefit amount to the employee, multiply the total benefit she received by the three-year average of the percentage of the premium you paid. For example, an employee receives an LTD benefit of $3,000 a month from a Group LTD whereby the premiums were paid by the employer and employee. For the three years before she received the LTD benefit, the employer paid on average 60 percent of the total premium, and she paid the remaining 40 percent in post-tax dollars. Therefore, $1,800 ($3,000 x 60 percent) will be taxable to her. The other $1,200 is not taxable to her because she paid for this portion of the total premium with post-tax dollars.
This article, slightly modified to note recent updates, was featured online in the Wisconsin Employment Law Letter and published by BLR®—Business & Legal Resources. Reproduced here with the permission of BLR®—Business & Legal Resources.