With the federal income tax deadline passing, most people won’t think about next year’s taxes until next January. But if you anticipate receiving long term disability benefits over the next 12 months, you should think about how your 2017 tax return could be affected. Essentially, knowing what benefits are considered taxable income (as opposed to tax-free) is critical for a number of reasons.
Generally speaking, the question of whether your benefits will be taxable depends on how you paid your insurance premiums. If you used pre-tax dollars to pay them, chances are that the benefits you receive will be considered taxable income. If you used after-tax dollars to maintain premiums, chances are that your benefits will be tax free.
The reasoning behind this is simple. Using pre-tax dollars to make premium payments reduces your taxable income in the year you made the payments. So you essentially receive a tax benefit before receiving any income from the policy. The tax code doesn’t allow taxpayers to “double dip” when it comes to tax savings in that regard. So if you used after-tax dollars to make premium payments, you did not get a similar tax benefit. In these cases, you will likely get that benefit on the back end by receiving tax-free benefits.
Knowing this difference is especially important in the midst of negotiating a settlement (or buyout) of an insurance plan. While finally receiving benefits after a legal battle is compelling, you certainly don’t want to sacrifice more income to Uncle Sam than you really have to. Also, what may seem like a generous offer from an insurer may not be after considering the tax hit you may take.
The preceding is not legal or tax advice.