Is Long-Term Disability Always Taxable?

Long-term disability (LTD) insurance is a type of private disability benefit that pays a percentage of your usual wages if you become unable to work. Most people who have LTD insurance get it as a benefit through their employer, who pays part (or all) of the insurance premiums. The amount your employer paid in premiums can then be taxed as ordinary income if you later need to collect LTD benefits.

Not all LTD benefits are taxable, however. And because many LTD insurance policies also require you to file for Social Security disability benefits, you may end up with a large lump-sum back payment that comes with its own tax implications. The interaction between Social Security and LTD insurance payments can be complex, so it’s a wise move to understand some of the basis before you end up owing the IRS more than you expected.

When Is Long-Term Disability Taxable?

If your employer pays 100% of your LTD premiums as part of a group plan, you’ll owe income taxes on all of the resulting LTD payments, because the premiums for the policy were paid for with before-tax dollars.

If you and your employer split the cost of the LTD premiums, only the amount of the payments attributable to your employer’s premiums is taxed as income. For example, if you pay 60% of your premiums and your employer pays the other 40%, if you receive $1,000 per month while on long-term disability, 40% of that $1,000 ($400) is taxable.

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.

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

Many LTD insurance policies also require you to file for Social Security disability benefits, expecting that you’ll then pay the LTD provider back should you win your case. Because it can take several years before your Social Security claim is approved, you may end up with a significant amount of past due benefits—money that Social Security owes you for the time when you were disabled but waiting for a decision—some of which can be taxed in addition to the LTD payments.

If you've received many months of LTD benefits by the time your Social Security claim has been approved, the LTD insurance company will want you to give back some of that money to offset what they've been paying you. (This is called "retroactive reimbursement of overpaid benefits.") You might find that you owe most or all of the Social Security backpay to the LTD company, and your lump-sum payment from Social Security may be taxable even if you owe it to the LTD carrier.

Tax Implications of Combined LTD and Social Security Benefits

Most people will have paid taxes on their LTD benefits, and then they'll have to pay taxes on their Social Security back benefits. But you may have to pay the LTD company the full, gross amount of the past-due benefits (not subtracting what you paid for taxes). Fortunately, the IRS can allow you to deduct (or receive credit for) the amount of Social Security benefits that you had to give back to the LTD insurer on your income tax return.

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 LTD payments are considered "earned income" (meaning you worked for them) rather than "unearned income."

If your employer paid for the premiums, your LTD payments are considered earned income (because they’re a benefit of your continued employment). Premiums that you paid for yourself are considered unearned income, since you used after-tax income to pay for them.

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—you can do this 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 Getting a Large Tax Bill

Some people who receive long-term disability benefits and apply for Social Security save part of their LTD checks in case they have to pay an eventual tax bill. Keep in mind that not all Social Security benefits are taxable—if your combined income (including SSDI benefits) is less than $25,000 ($32,000 for couples), you won’t owe any income tax. (SSI benefits are never taxed.)

If you do get a bill from the IRS, you may want to set up a payment plan where you can pay your tax liability in installments over a set period of time.

Figuring how much you owe when both LTD payments and Social Security benefits are involved can quickly get very complicated, so if you’re receiving LTD and expect to receive a large lump sum from Social Security, it’s a good idea to consult with a tax professional.