When Disability Benefits Are Taxed

Dear Tax Talk,I am employed by a company that offers its employees several insurance plans that they can elect to receive. However, unlike a cafeteria plan, we pay 100% of the premium through payroll deduction. I recently injured my back and used my short-term disability insurance, which is 66.7% of my gross pay. In my case, the insurance company informed me that it pays my claim through my company's payroll, and it authorized $1,159 for my first 12 days of pay. But when I got paid, it was $790. I contacted my company payroll office and they said they had to tax the original amount. I also receive $4.05 per hour for health and welfare benefit, and they taxed it also. From what I find in IRS Publication 525, this is not supposed to be taxable income. What is your answer to this?-- John

Dear John,While your back may have been sore, now it's your wallet that's hurting. The key to taxation of disability or heath benefits pay is whether the premiums were paid with pre-tax or after-tax dollars. Premiums paid from a cafeteria plan arrangement are considered pre-tax dollars. That is, you're not paying income tax on the money that is offered through a cafeteria plan arrangement.

IRS defines the arrangement of a cafeteria plan as including a flexible spending plan, which is a written plan that allows employees to choose between receiving cash or taxable benefits instead of certain qualified benefits for which the law provides an exclusion from wages. In practice, a cafeteria plan is best described by an example.

The most basic cafeteria plan, or CP, is a premium-only CP. The plan is created by the employer to pay only the portion of the employee's health insurance premiums not paid by the employer without subjecting the deduction to payroll taxes.

For example, let's assume an employer requires that an employee pay $100 a month for his or her health insurance. Assume the employee earns $5,000 a month. With a cafeteria plan, the employee's payroll taxes are calculated as if his or her gross pay were only $4,900.

Assume that all of the payroll taxes are 20%. With a cafeteria plan, the employee's taxes of $980 plus $100 are deducted from the $5,000 gross for a net take-home pay of $3,920. Without the plan, the employee's taxes would be $1,000, for a net take-home pay of $3,900. The CP saved the employee $20, or 20% of the $100 payroll deduction.

In the example, the cafeteria plan is a pretax arrangement; without the CP, it is an after-tax arrangement. If your disability premiums were paid after tax, then there should have been no payroll taxes deducted.

The Internal Revenue Service's Publication 15-A provides as follows:

Social Security, Medicare and FUTA taxes do not apply to payments, or parts of payments, attributable to employee contributions to a sick pay plan made with after-tax dollars. Contributions to a sick pay plan made on behalf of employees with employees' pre-tax dollars under a cafeteria plan are employer contributions.

The reasoning behind the exemption is quite simple. If you pay the premiums, you receive no tax benefit, so therefore the benefits received are tax-free.