Because virtually every Social Security office in the country has a substantial backlog of disability cases, most people who are approved for Social Security disability or SSI benefits don't receive their first payment until many months, or even years, after filing their initial application. The good news is that if you're approved, Social Security will pay you "back benefits" for most or all of the months that you've waited. This amount is paid in a lump sum, and it can be substantial.
Many people wonder about the tax implications of receiving this lump sum. Is it taxable income? Can it bump me into a higher tax bracket? Can I apply the back payments to prior years' income if I'm receiving payments accrued over multiple years? Do I have to amend prior years' returns to do this? Here are a few things to keep in mind when filing your taxes after receiving a lump sum back payment from Social Security.
While you might have to pay taxes on a small portion of your lump sum payment from Social Security, the IRS does not penalize disability beneficiaries for receiving past-due benefits all in one year. Federal law provides that individuals can apportion past-due benefits to previous years, thus lowering or eliminating the taxable amount of their lump sum per year, without having to file amended tax returns.
Social Security sends beneficiaries a form called the SSA-1099 each year they receive benefits. If you're receiving this form for the first time, it should state in Box 3 the exact amount of your lump sum that was accrued during previous years. Each year will be listed separately alongside the total amount paid for that year. Rather than requiring you to file amended returns for those years, the IRS allows you to handle it all on your current tax return, using prior years' income amounts. This method is discussed in IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits. (This often isn't an issue for SSI backpay, because large amounts are paid in three small installments six months apart.)
While IRS Publication 915 provides a way to calculate how much of your lump sum payment is taxable, the formula is highly technical and confusing for the majority of people. It is recommended that you contact a tax professional or purchase tax prep software to assist you in filing your taxes after you receive your lump sum back payment from Social Security. While these options are not free, they could help you avoid overpaying your taxes by a much larger amount.
Whether you'll owe federal income tax while receiving Social Security disability depends on whether you file individually or jointly and how much "provisional income" you report. Provisional income includes your adjusted gross income (AGI), any tax-exempt interest you earned, and half of your Social Security disability benefits.
If disability benefits are your only source of income, you'll almost certainly not owe any federal income tax. But if you're filing as an individual with provisional income between $25,000 and $34,000, up to 50% of your disability benefits are considered taxable income. If you have provisional income over $34,000, 85% of your benefits are taxable.
If you're married filing jointly and have a combined income over $32,000, up to 50% of your disability benefits are taxable. Combined income over $44,000 will cause up to 85% of your disability benefits to be taxable. Remember that the 50% and 85% figures refer to the amount of income that is taxable, not to your marginal tax rates. Any disability income that is taxable will be taxed at your ordinary marginal rate (which, for most people, is between 10% and 28%).
Of course, you could owe state taxes on your disability backpay, but most states don't tax Social Security disability benefits. About a dozen states do tax benefits, however, either the same way as the feds or only if you make over a certain amount of adjusted gross income. For information about your particular states, see our article on state taxation of Social Security disability benefits.
Each year only a fraction of Social Security Disability Insurance (SSDI) recipients owe federal income taxes, usually because a spouse is working or the recipient has passive income from rental properties or investments. As for Supplemental Security Income (SSI), because of the SSI income limits, almost no SSI beneficiaries earn enough to owe income tax. As a result, Social Security does not automatically withhold any of your disability lump sum amount, or any of your monthly check, for tax purposes.
However, if you anticipate having to pay federal income taxes on your disability payments and wish to avoid owing a large amount when you file your taxes, you can set up Voluntary Tax Withholding (VTW) through IRS Form W-4V. (Notice that Line 6 of the form allows you to withhold only 7%, 10%, 15%, or 25% of your monthly benefit.) Once completed, this form should be sent to your local Social Security office. However, you should really consult a tax professional before setting up VTW, as tax withholding is unnecessary in most cases.
Most lawyers who handle Social Security disability cases charge a standard fee of 25% of your past-due benefits, with a cap of $6,000. (The fee may work somewhat differently if your case goes to the Appeals Council or requires multiple hearings.) If you win your disability claim, Social Security will pay the attorney fee directly to your lawyer, and you'll receive the remainder.
If some of your lump sum turns out to be taxable, you can deduct the fee paid to your attorney from your disability benefit income, but only on a pro rata basis. For example, if 40% of your lump sum payment was counted as taxable income, you may deduct 40% of your attorney's fee. You list this deduction on Schedule A of your return, under miscellaneous deductions. Note that you must file an itemized return to claim this deduction, and that you can deduct only the amount that exceeds 2% of your adjusted gross income.
Learn more about how much disability backpay you'll receive.