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Disability insurance: Pick your tax poison

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in Small Business Tax,Small Business Tax Deduction Strategies

Employer-paid disability income (DI) insurance can be a valuable fringe benefit for employees, but it comes with a potential tax price. Depending on how you handle things, you may have to pay tax on the coverage sooner or later.

Strategy: Weigh your options. Then choose the tax route that’s best for your particular situation.

Essentially, the choice boils down to paying tax on coverage up front so any future benefits will be tax free or having to pay tax if you should ever receive benefits. Frequently, the decision will depend on a combination of your age and health status.

Here’s the whole story: With a company accident or health insurance plan, such as a DI insurance plan, the premiums paid by the employer are tax free to employees. If the DI plan is contributory—in other words, financed partially by both the employer and the employee—any amounts paid for disability benefits are taxable to employees to the extent they are attributable to tax-free employer contributions.

Thus, an employee who receives DI benefits must either pay tax on the coverage provided under the company plan or the benefits when they are received. You can receive only one tax break in this equation—tax-free coverage or tax-free benefits—but not both.

What should you do? There’s no definitive “right” or “wrong” answer.

Rule of thumb: When you’re young and in top shape healthwise (i.e., not at a high risk for suffering a disability), you might opt for tax-free coverage. Conversely, as you close in on retirement, you may favor tax-free DI payouts and elect to pay tax on the coverage. This is especially true if you are known to have health-related issues.

Tip: The IRS has previously ruled that employees can elect to pay tax on DI coverage even if they have received tax-free coverage in prior years. (IRS Revenue Ruling 2004-55)

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