Nobody thinks they’ll become disabled, yet the statistics on the occurrence of disability deserve attention. The Society of Actuaries reports that a 35-year-old is three-and-a-half times more likely to become disabled before age 65 than to die. Long-term disability insurance may possibly qualify as the most overlooked insurance coverage—until it’s too late. The annual open enrollment period presents an opportunity for employees, employers, and their advisers to focus on this important benefit, especially the strategic income tax implications.
Many employers offer group long-term disability (LTD) insurance plans. Group LTD plans are popular because of their relatively low premium cost and ease of underwriting since no physical examination is usually required to qualify for coverage. Benefit calculations under group plans are often set at approximately 60% of pre-disability compensation, a historical percentage that appears to be an accepted proxy for the relative spendable after-tax income that employees generally receive from their compensation.
Yet the expectation that post-disability spendable income will approximate 60% of pre-disability income may be mistaken. One reason is that the definition of covered compensation to which the 60% factor applies can vary from plan to plan. For example, some plans limit covered compensation to base salary and exclude variable compensation, such as bonuses and equity awards. A second reason is that group LTD plans typically have a monthly maximum dollar benefit, which places an absolute limitation on the benefits a participant can receive. Finally, group plans normally have a waiting period of up to six months and generally require the calculated plan benefit to be offset by any Social Security disability benefit for which the employee qualifies.
Employees might also purchase supplemental employer or private LTD products. These products are generally targeted toward higher-income professionals and executives and allow for more flexibility in benefit design but require a higher premium. Coverage can be obtained to cover a beneficiary’s “own occupation,” as opposed to “any occupation,” as well as the decreases in income that could result from a partial disability.
Waiting periods are elected by the policy owner and might be as short as 30 days, depending on the premium option chosen. The amount of monthly benefit is generally selected by the insured, not always subject to a Social Security offset, and may have a level of inflation protection through a cost-of-living rider. Such insurance products typically require the employee to submit to an underwriting process, and they’re priced accordingly.
Premiums for private LTD coverage are generally paid solely by the employee with after-tax dollars, while premiums for a supplemental or group LTD plan might be paid by the employee, the employer, or both. Often employers allow the employee to affirmatively elect to pay the premium on either a pre-tax or post-tax basis. Even if the employer economically funds all or part of the premium, it’s possible for the plan to provide that eligible employees may elect to be taxed currently on the premiums paid by the employer (Rev. Rul. 2004-55).
Although employer-paid premiums or a pre-tax deduction for employee-paid premiums provide a cash-flow benefit to the employee, either approach may result in the employee’s receiving a minimal current benefit while potentially facing a significantly larger future income tax liability in the event of a disability. This outcome can result because the income tax treatment of future disability income depends on two factors: (1) the source of the benefit (Social Security or employer/insurer) and, most importantly, (2) whether the premiums were paid with pre-tax or post-tax dollars.
INCOME TAX TREATMENT OF DISABILITY BENEFITS
Group LTD plans routinely provide that disability benefits from the employer/insurer are offset (reduced) by the amount of the benefit provided by Social Security Disability Income (SSDI). Thus, a good portion of disability benefits under group LTD plans are funded by employer and employee payroll taxes.
The Social Security Reform Act of 1983 was game-changing in that it opened the door to the federal taxation of Social Security. Under Internal Revenue Code (IRC) §86, up to 85% of any type of Social Security benefit may be taxed for federal income tax purposes. This direct federal taxation of SSDI is triggered at very modest income levels and has become more pronounced due to the annual cost-of-living increases in SSDI payments, while the statutory income threshold triggers in IRC §86 remain fixed in 1983 dollars and aren’t indexed for inflation.
Further, the increase in adjusted gross income (AGI) for taxable SSDI may also have an unfavorable cascading effect since AGI is a critical metric in the federal income tax formula that indirectly triggers a number of phaseouts and limitations in the computation of federal income tax and the qualification for federal benefits, including medical expense deduction and the AGI-based Income Related Monthly Adjustment Amount (IMRAA) surcharges for Medicare Parts B and D, respectively. Due to IRC §86, employees have little control over the fact that federal taxation of SSDI will erode the net after-tax post-disability disposable income.
As to the portion of the disability benefits paid by the employer/insurer, IRC §104(a) provides an exclusion from gross income for any amount received from accident and health insurance plans for personal injuries and sickness where the benefit received is attributable to after-tax contributions for the purchase of an individual policy or the inclusion of the employer contribution in the gross income of the employee.
On the other hand, IRC §105(a) clearly provides that the same disability benefits are taxable to the extent they are (1) attributable to contributions by the employer that weren’t includable in the income of the employee or (2) are paid by the employer. Thus, if the employee pays the premium or is treated as having paid the premium with after-tax dollars, the portion of the disability benefit attributable to the after-tax premium is excluded from gross income.
The opportunity to elect after-tax payment of premiums is normally part of the annual benefits enrollment process and shouldn’t be overlooked by employees. Where such an election isn’t currently available, employers should consider modifying their program to enable the election given the long-term benefit to employees who become disabled.
It’s critical that employees have a realistic understanding of their level of financial preparedness for a long-term disability. There’s a real possibility that post-disability cash flow needs will be higher than anticipated due to expenses such as caregivers, special equipment, and unreimbursed medical costs. Given the complexities of insurance and the tax law, it’s easy to have a mistaken impression about the amount of after-tax replacement income that a disabled employee will receive.
Although employers can’t advise on tax matters and the purchase of insurance products, they can leverage the opportunity provided with annual open enrollment to (re)educate employees about the critical importance of LTD coverage and the very favorable tax benefit resulting from a post-tax election for the payment of group LTD premiums.
© 2020 A.P. Curatola