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Spring 2009

The Taxation of Disability Insurance Premiums

Stephanie J. Zvolenski, MBA
Financial Manager, Anesthesia Business Consultants, LLC

Physicians—in fact most health care professionals—are diligent in the purchase of both short and long-term disability insurance policies to protect their personal income stream in the event of an accident or illness that may render them unable to engage in gainful employment.

Most people are selective about the types of policies that they choose, carefully considering occupation specific clauses as well as eligibility waiting periods for benefits, monthly income amounts payable by the policy and monthly premium costs. Few understand the tax implications both in the present and in the future of the payment of the policy premiums, however. Each insured has the option of remitting the monthly policy premium on either a pre-tax basis or a post-tax basis. A pre-tax basis means that the policy is paid either by the insured’s employer directly to the carrier or as a benefit paid that ultimately decreases the insured’s annual gross compensation by the amount of the monthly premium. A post-tax basis is defined as a net payroll deduction from the insured’s monthly payroll or as a personal payment from the insured’s monthly household budget.

As one would assume, if and when the insured should become disabled and need to cash in on the policy, the election of the payment method for the disability insurance premiums carries with it the taxation of those policy benefits. For example, if the insured elects to have his/her disability insurance premiums paid on a pre-tax basis either by his/her employer or through a decrease in annual gross compensation, then upon a determination of disability and distribution of the policy benefits any policy benefits paid to the insured will be treated as taxable income by the federal government subject to taxation at the insured’s then tax rate. On the other hand, should the insured elect to pay the policy premiums with post-tax dollars, e.g. through a net payroll deduction or as a personal payment from the insured’s own bank account, then upon distribution of the policy benefits at the time of declared disability,the insured will receive those benefits free of taxation.

The decision to pay the policy premiums on either a post-tax or a pre-tax basis is most often at the sole discretion of the insured, unless the disability insurance policy is offered as a group plan by the insured’s employer. In the latter case, the employer may have specific policies relating to the taxation of the payment of the policy premiums. If the decision to treat these premiums on a post-tax or pre-tax basis is left to the insured, considerations regarding other income sources, age, and tax status should be considered. Ultimately, insured individuals should seek the guidance of their personal financial advisors before making the decision.

Often, people find it necessary to change the tax basis of the payment of these premiums. For example, as one ages it may become more advantageous to pay one’s disability insurance premiums on a pre-tax basis, making them taxable upon distribution. A person early in his or her career may be more inclined to pay these premiums on a post-tax basis enjoying a tax free benefit upon distribution. Again, this decision can and should only be made based upon the considerations of future earning capacity, years to retirement, other income sources, etc.

Although it is not impossible or even difficult to make changes to the tax basis upon which one pays his/her disability insurance premiums, it must be understood that the Internal Revenue Service (IRS) is very specific regarding the taxation of the distributed benefits when there has been an inconsistent method of tax basis payment of the insurance premiums. The IRS utilizes a three-year look back rule for group insurance policies purchased with both employer and employee contributions when making a determination as to how disability insurance payments should be treated from a tax perspective. The IRS has determined that the taxation of disability insurance payments will be determined by the pro rata calculation of the method in which the premiums were paid in the prior three-year period. For example, if the individual becomes disabled in 2009, the IRS will consider all distributions to be tax free provided that the disability insurance premiums for 2007, 2008 and 2009 were paid on a post-tax basis. However, if the premiums for 2007 were paid on a pre-tax basis and the premiums in 2008 and 2009 were paid on a post-tax basis, the IRS will treat one-third (1/3 or 33.33%) of the individual’s monthly distribution as taxable and the other two-thirds (2/3 or 66.67%) will be received by the insured tax-free.

The IRS does offer an alternative to the three-year look back rule. Each individual may make an irrevocable annual written election for the tax basis treatment of that year’s disability insurance premiums. Based on that irrevocable written election, any disability insurance distributions received will be taxed or not taxed dependent upon that election. The intent of the irrevocable election is to prohibit those who were not deemed disabled during the policy period and who paid the respective disability insurance premiums on a post-tax basis for the entire year from changing the payment method to a pre-tax basis at year-end.

The taxable portion of benefits paid by an individual disability insurance policy purchased with both employer and employee contributions is determined by the ratio of premiums paid by the employer to the total premiums for the current policy year.

Disability insurance is an extremely important benefit for physicians and all health care professionals. The tax treatment of the insurance premiums and the associated distributed benefits are also vitally important to one’s personal finances. It is advisable that you confer with your personal financial consultant before making any elections regarding the tax treatment of your monthly disability insurance premiums.