Most long-term disability (LTD) policies contain a provision that requires those who receive LTD benefits to file for Social Security disability benefits. Then, if the Social Security applicant is approved for disability, the LTD insurance company is allowed to reduce (or "offset") the monthly LTD benefit by the amount of Social Security disability payments received. For example, when a person who receives $2,000 in long-term disability benefits per month is approved for $1,800 in Social Security disability, he can still collect a total of $2,000, but $1,800 will come from Social Security and the remaining $200 from the LTD insurance carrier.
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 a substantial lump-sum amount of Social Security benefits is paid to the applicant, possibly after having received many months of LTD benefits. Because the LTD insurance company can seek retroactive reimbursement of overpaid benefits, the applicant may find that most or all of the Social Security backpay is owed to the LTD carrier.
While long-term disability benefits are not taxable (when provided as a company benefit), Social Security disability payments can be taxed if you earn other income. (For more information on taxation of disability backpay in general, read How Is Social Security Disability Backpay Taxed?) It's important to remember that up to 85% of your lump-sum payment from Social Security may be taxable even if it's owed to the LTD carrier. Because the taxable Social Security disability benefits effectively take the place of the tax-free LTD payments, many disability recipients are 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. (Under IRS rules, up to 85% of Social Security benefits may be considered taxable income at regular marginal rates.) 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 LTD payments.
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, disability recipients need not file amended returns for previous years; the situation can be addressed on one's 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.
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 backpay.