Let's look at business owners to see if they can take a deduction for the premiums:
- Sole Proprietor - A sole proprietor is the sole owner of a business. Sole proprietors usually file a Schedule C (where the tax deductions are taken). The issue is that sole proprietors are not considered employees but self-employed; thus, the premiums are not tax-deductible. The benefits would be received tax-free.
- Partnerships - The income from a partnership is not federally taxed, and income (or loss) flows to the partners, who are taxed based on their proportionate share of the partnership's profits. Although the partnership can deduct the premiums paid to the partners as a guaranteed payment, the premiums are included in the partner's income. This means that although the partnership could make a deduction, the partner would pay tax on the premiums. The benefits received would be tax-free.
- S-Corporation - This is taxed very similarly to a Partnership, whereas the corporation does not pay federal tax, and the income (or loss) is passed to the shareholders proportionately. The laws allow an S-Corporation to deduct the premiums, but if the owner owns more than 2% of the shares, the premiums are included in his/her income, making the benefits tax-free. In essence, the business deducts the premiums from both a partnership and an S corporation. Still, the premiums are included as income, so it is a wash to the shareholder/partner, and benefits are received tax-free.
- C-Corporation - C-Corporations are separate legal identities that file their tax returns and pay their tax. The corporation can deduct the premiums if you are a shareholder and an employee. If they do, the benefits received would be taxable. There can also be cost-sharing, where the corporation pays the premiums, and the employee/shareholder is taxed on part of the premiums. In that case, the percent of premiums that the shareholder pays taxes on would be received tax-free. For example, if the premiums for shareholder X are $3,000 annually and the shareholder elects to include $1,000 in his taxable income, he would receive one-third of the benefits tax-free.
Many employers offer group disability insurance to their employees. Most of the time, the employer pays the premiums, and the benefits received are taxable to the employee. Some companies offer the employee the option to pay all or some of the premiums with after-tax (not deductible) dollars or to include the premiums on their W-2. In this case, the portion of the benefits paid for with after-tax dollars is not taxable, and the other portion the employer pays for only would be taxable.
Let's look at an example. XYZ Corporation provides employee Y disability insurance benefits with an annual premium of $1,000.
- Scenario 1. XYZ Corporation pays for all premiums. The benefits received are taxable to employee Y.
- Scenario 2. The entire premiums are paid for by the employee or included in their W-2 at the end of the year- The benefits received would be tax-free.
- Scenario 3. Half of the premiums are paid for by the employee or included in their W-2 at the end of the year. Half of the benefits received would be taxable, and the other half tax-free.
As discussed above, it may not be in your best interest to take a deduction for disability insurance, even if you could. If you had never become disabled and never collected benefits, it would have been a better choice to take the deduction. The problem is no one knows what the future holds. If you had become disabled, then you would probably have been much better off not taking the deduction since the benefits would have been received tax-free.
Let's look at an example of a 35-year-old attorney with a $5,000 monthly benefit, cost-of-living rider, and an annual premium of $1,500.
- If that person became permanently disabled soon after the purchase of the policy and remained disabled until age 65, the potential payout would be about $2,800,000. If he is in a 25% tax bracket, he would have paid over $700,000 in taxes on the benefits, if he was able to, and deducted the premiums on his taxes.
- If he did not, the entire $2,800,000 would have been tax-free. If he was in the same 25% tax bracket, took the tax deduction, and never became disabled, he would have saved about $11,250 in taxes ($1,500 annual premium times 30 years times 25% tax bracket). Is it really worth the small savings to pay a potentially huge tax in the future?
So, is disability insurance tax deductible? Again, maybe, maybe not.
