Income Tax and Disability Benefits

How do you know if your insurance coverage is adequate to protect you if you are sick or hurt and unable to work? Few question the importance of having disability insurance, but just because you have it does not mean you are well protected.

Let's suppose someone has a typical employer provided plan which pays 60% of income up to a $10,000 per month maximum. If our test subject's income is $100,000 per year or $8,333.33 per month, then their benefit would be $5000 per month; half of the maximum benefit. As long as their monthly expenses are less than $5000 a month they should be in good shape… but what about taxes?

Taxation of disability benefits is straight forward. You must pay tax on either the premium or the benefit. In most cases with employer provided disability coverage, the employer gives the insurance as a non-taxable benefit to the employee and writes off the premium as a business expense. Put another way, neither the employee nor the employer has paid income tax on the premium so the benefit is fully taxable. At a minimum, $5000 per month is in a 15% marginal tax bracket which would net $4250 per month. Depending on the taxpayer's filing status or if there was additional income in the household the marginal tax rate could be significantly higher. So in the best case scenario our test subject who earns $8000 per month only has insurance protection for 53% of their income, not the 60% they thought.

As long as the 53% still fit into their spending patterns there is no need to do anything else. But how many people realistically live off half their income?

The solution is to purchase a supplemental insurance policy to provide benefits above the employer provided plan. In our example scenario, if the employee's "magic number" is $5000 per month they should purchase a disability plan which provides an additional $750 per month. Since the benefit is pretty small in most cases the premiums would be quite affordable. Just make certain the supplemental plan does not reduce based on employer provided benefits.

Related Resources:

Do You Need Disability Insurance? @ SmartMoney.com

Time For Disability Insurance? @ The Wealth Channel

Photo DJ G in the Hospital by CarmanAvenue