Is Long-Term Disability Taxable, Even If the Company Takes My Social Security Backpay?

Long-term disability (LTD) payments can pay a percentage of your salary or wages if you become unable to work. Most people who have long-term disability benefits get them through an employee group benefit. (Learn the basics about LTD benefits.)

Is Long-Term Disability Taxable?

If you receive LTD payments as an employment benefit, you'll owe income taxes on those payments, because the premiums for the LTD policy were paid for with before-tax dollars (your employer paid for the policy through an employer-provided group plan).

If you happen to have an individual LTD plan that you pay for with your own after-tax dollars, you won't pay taxes on the LTD benefits, since they're not considered taxable income.

If you pay part of the LTD premium and your employer pays part of the premiums, only the portion of the LTD payments attributable to your employer's premiums is taxed as income.

Can My Insurance Company Take My Social Security Disability Payments?

Most long-term disability (LTD) policies require you to file for Social Security disability benefits after you start to receive LTD benefits. If you're approved for disability, the LTD insurance company is allowed to reduce (or "offset") your monthly LTD benefit by the amount of the Social Security disability payments you receive.

For example, say Lucas is receiving $2,000 in long-term disability benefits per month when he's approved for $1,800 in Social Security disability. He can still collect a total of $2,000 per month, but $1,800 will come from Social Security and the remaining $200 from the LTD insurance carrier.

Can My Long-Term Disability Company Take My Social Security Backpay?

In many cases, Social Security only awards disability benefits after a lengthy process of many months or even years. This can create a situation in which you receive a substantial lump-sum amount of Social Security benefits—money that Social Security owes you for the months when you were disabled but waiting for a decision.

If you've received many months of LTD benefits by that point, the LTD insurance company will want some of that money to offset what they've been paying you. So they will seek what they call "retroactive reimbursement of overpaid benefits." You might find that you owe most or all of the Social Security backpay to the LTD company.

Is Social Security Disability Back Pay Taxable?

Social Security disability payments can be taxed if you earn other income. Up to 85% of your Social Security benefits can be taxed if you or your spouse has a lot of other income. For more information on the taxation of disability backpay, read How Is Social Security Disability Back Pay Taxed?

Do I Have to Pay Taxes on the Back Pay I Give to the LTD Company?

Your lump-sum payment from Social Security may be taxable even if you owe it to the LTD carrier. If your LTD payments have been tax-free because you paid for an individual policy with your own money, and then you get taxable Social Security disability benefits, you might be left facing a hefty tax bill from the IRS, without the money from Social Security to pay it.

In one case, a woman began receiving long-term disability benefits in 2007 and was finally awarded Social Security disability payments in 2010 after applying three years earlier. Nearly all her back pay from Social Security, which totaled more than $49,000, went to the LTD carrier under the terms of the policy. The IRS then presented a tax bill to the woman and her husband of more than $10,000. While the Tax Court sympathized with the couple's plight, ultimately it was bound by federal law, which taxes Social Security disability benefits but not all LTD payments.

Most people will have paid taxes on their LTD benefits, and then they'll have to pay taxes on their Social Security back pay. But you may have to pay the LTD company the full, gross amount of the back pay (not subtracting what you paid for taxes). Fortunately, the IRS does allow you to take a deduction for the amount of back pay you included in your income. But talk to a tax professional if you find yourself in this position; this is where things get very complicated.

Is Long-Term Disability Considered Earned Income?

If you're going to claim the Earned Income Tax Credit (EITC), you need to know which types of income are considered "earned" (meaning you worked for them), rather than "unearned."

As with the taxation of LTD benefits, whether long-term disability payments are earned income depends on who pays for the policy premiums. If your employer paid for the premiums, your LTD payments are considered earned income, because they're a benefit you earned as an employee.

If you paid for the premiums for the policy, your LTD payments don't qualify as earned income. They'll be considered unearned income since you used after-tax income to pay for them.

SSDI and SSI payments are always considered unearned income when you claim the EITC.

Spreading Out Social Security Backpay to Lower Your Taxes

One bright spot is that the IRS allows disability recipients to apportion disability backpay to previous years' tax returns, which often lowers or eliminates the taxable portion of the lump sum.

Moreover, you don't need to file amend returns for previous years when you should have received the disability income; the situation can be addressed on your current tax return. For more on this method, consult IRS Publication 915: Social Security and Equivalent Railroad Retirement Benefits.

In practice, most individuals and couples whose only income comes from disability benefits will face little to no taxes if their lump sum is apportioned to previous years.

How to Avoid a Getting a Large Tax Bill You Can't Pay

Some people who receive long-term disability benefits and apply for Social Security save part of their LTD benefits in case they have to pay an eventual tax bill. If you're receiving LTD benefits and expect to receive a large lump sum from Social Security, you may want to contact a tax professional immediately to discuss the tax implications of your Social Security backpay.

_{Updated January 31, 2023}