Plan Ahead to Make Disability Benefits Tax-Free
If you're an employee of your practice, you may receive company-paid long-term disability insurance coverage as a tax-free fringe benefit.
Sounds good but here's the problem: Most long-term disability policies limit benefit payments to only 60 or 70 percent of your normal salary before taxes. That's generally enough coverage -- as long as you don't owe income taxes on the benefit payments. But if you do owe income taxes, you'll probably have to cough up at least 30 to 40 percent to the IRS and your state tax collector. When benefits are already limited to only 60 or 70 percent of your usual pre-tax salary, this tax bill can create serious financial hardship. For example, a disability insurance benefit of 60 percent that gets taxed at 30 percent equates to only 42 percent of your normal salary. In the event of a disability, that may not be enough to live on comfortably.
That's the bad news. Fortunately, there's some good news. You can arrange for your long-term disability insurance benefits to be free from federal income tax (and usually state income tax as well) by paying the premiums with your own money -- as opposed to having the practice pay them as a tax-free employee fringe benefit. For tax purposes, even when you pay for employer-arranged group coverage with after-tax dollars via withholding from your salary, you're considered to be paying with your own money. Therefore, your long-term disability benefits are tax-free.
Consider Implementing this Solution
Arrange for the premiums for your disability coverage to be paid with after-tax dollars. In other words, the company-paid premiums will be treated as additional taxable salary paid to you. The practice, as your employer, can continue to make the actual premium payments directly to the insurance company just as it did before. (IRS Private Letter Rulings.200146010, 200146011 and 200146012) Your salary can even be increased to make up for the disadvantage of not receiving disability coverage as a tax-free fringe benefit. (IRS Private Letter Ruling 199930015) However, it may be prudent to avoid any verifiable link between a salary adjustment and your decision to pay disability insurance premiums with after-tax dollars.
Bottom line: This strategy converts your long-term disability benefits into tax-free dollars. Of course, it also increases your current income tax bill a small amount because your taxable salary is now a bit higher. In most cases, however, the extra taxes you pay now are a small price for gaining the more valuable advantage of tax-free disability benefit payments in the event you are unable to work later on.
If you decide to implement this strategy for yourself and other partners, you don't have to change the way you treat rank-and-file employees at your practice. However, don't wait too long to take action. A disabling injury or illness could strike at any time. Contact your tax adviser if you have questions.