The Tax Implications of Disability Income

By: Sidney Kess, JD, LLM, CPA and Aaron Moss, JD

 

The Centers for Disease Control and Prevention (CDC) reports that 61 million adults in the United States have some type of disability affecting mobility, cognition, hearing, or vision (https://bit.ly/3ujKOlv). According to the Council for Disability Awareness, just over 1 in 4 of today’s young adults will become disabled before retirement. Surprisingly, 90% of disabilities are caused by illnesses, not accidents (https://bit.ly/3LnP2zF). One-quarter of disabilities will last for three months or longer, and these disabilities might prevent or limit self-care, independent living, or the ability to work. Financial assistance may be available through government programs, insurance, or employer plans. The source of this income dictates the tax results.

 

What is Disability?

The dictionary defines “disability” simply as a physical or mental condition that limits a person’s movements, senses, or activities. But disability income programs and the tax law use different definitions of disability for different purposes.

 

The Social Security Administration defines disability as an inability to engage in any substantial gainful activity (SGA) because of a medically determinable physical or mental impairment that has lasted, or is expected to last, at least one year, or is expected to result in death.

 

Children under 18 are considered disabled if they have a medically determinable physical or mental impairment that very seriously limits their activities; such condition must have lasted, or be expected to last, at least one year or result in death.

 

The Social Security Administration has two programs that are potentially available to individuals who meet SSA’s definition of disability: Social Security Disability Insurance (SSDI) and Supplemental Security Income (SSI).

 

SSDI is a federal program funded by payroll taxes to insure workers against severe disabilities. SSDI is available to individuals who have a medically determinable impairment that restricts their ability to engage in substantial gainful employment, if they have not yet reached their full retirement age for purposes of collecting Social Security retirement benefits. SSDI is not dependent upon a person’s financial situation. To qualify for SSDI, an individual must be “insured” for Social Security benefits; generally, this means that the person must have worked for at least 5 out of the last 10 years before being impaired by a serious physical or mental disability that has lasted, or is expected to last, at least one year, or result in death. Only about 50% of applicants are determined to be medically eligible for SSDI.

 

SSI is a means-tested government program for disabled adults and children who have income and assets below mandated thresholds. SSI is also available to individuals who are not disabled, but are over 65. (SSI benefits are paid out of general tax revenues and not out of Social Security taxes.)

 

The Social Security Administration uses the same definition of disability for both SSDI and SSI.

 

Definition of Disability for Exception to the 10% early distribution penalty.

A person who takes a distribution from a qualified retirement plan or IRA before age 59½ is subject to a 10% penalty unless disabled [IRC section 72(m)(7)]. The definition of disability for this purpose mirrors the definition used for purposes of Social Security disability: An individual is considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that is expected to result in death or be of long-continued and indefinite duration.

Definition of Disability to be considered “eligible designated beneficiary” for required minimum distributions (RMD).

Individuals who inherit a retirement account from a decedent dying after 2019 are subject to a 10-year distribution rule unless they are an “eligible designated beneficiary.” Being disabled allows a designated beneficiary to be eligible for this designation. Under proposed regulations (NPRM REG-195954-20, 2/23/22), if a designated beneficiary is under age 18 when the account owner dies, the designated beneficiary must have a “medically determinable physical or mental impairment that results in marked and severe functional limitations, and that can be expected to result in death or be of long-continued and indefinite duration.” If the designated beneficiary is older, then the definition of disability is the same as the one used for early distribution penalty purposes (i.e., being unable to engage in substantial gainful activity). There is also a safe harbor that uses the Social Security definition of disability, which includes chronic illness.

Definition of disability for workers’ compensation.

Employees who suffer a work-related injury or illness may be eligible for workers’ compensation benefits. Permanent disability benefits become payable if the employee has not made a full recovery but the condition has stabilized (i.e., “permanent and stationary”).

Definition of disability for commercial (private) disability policies.

The definition of disability for private disability policies is set by the terms of the contract—and depends upon whether the policy is for short-term or long-term coverage. It may, for example, pay benefits even if a person is able to continue to do some work.

 

How Are Disability Benefits Taxed?

Different disability benefits receive different tax treatments.

Social Security disability income.

SSDI is treated exactly as Social Security retirement benefits are; benefits may be tax free or includible in gross income at 50% or 85%, depending upon the individual’s other income (IRC section 86). More specifically, benefits are includible in gross income if the total of 1) one-half of the benefits, plus 2) all other income, including tax-exempt interest, is greater than the base amount for the person’s filing status. The base amount is $25,000 for single, head of household, qualifying widow, and married filing separately if the taxpayer lived apart from their spouse for the entire year; $32,000 if married filing jointly; and $0 for married filing separately if the taxpayer lived with their spouse at any time during the tax year. Married persons filing a joint return must combine incomes and Social Security benefits when figuring the taxable portion of the benefits.

 

Individuals who become eligible for SSDI may receive “back pay” in a lump sum. Disability payments can only start 5 months after the date of disability onset established by Social Security; however, the maximum period eligible for retroactive pay is 12 months prior to the date one filed for SSDI. Even if the back pay relates to a prior year, no amended return is used to report the payment; it is reported on the return in the year it is received. Taxpayers, however, have an option as to the amount of income to include:

• Use the current year’s income to figure the taxable part of the total benefits received in the current year, or
• Make an election to figure the taxable part of the lump-sum payment for an earlier year using income from that year. The details of this option are explained in IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits.

Workers’ compensation benefits reduce SSDI [IRC section 86(d)(3)]. Although workers’ compensation benefits are tax free, the extent to which they reduce SSDI means they are effectively includible in gross income to the extent described above. For example, a taxpayer could be in a better after-tax position by not applying for SSDI, because workers’ compensation payments can effectively become taxable (see John C. Thompson, TC Summary Opinion 2016-20).

Disability pensions.

Employer-paid disability pensions are treated as taxable compensation (wages) until one attains retirement age. At that time, if the payments continue, they are taxed as pension or annuity income.

Payments from a commercial disability policy.

If premiums for a commercial disability policy are paid with after-tax dollars, then benefits under the policy are tax free (IRC section 104). If they are paid with pre-tax dollars (e.g., an employer paid the premiums and treated this as a tax-free fringe benefit, or an employee paid the premiums through a cafeteria plan that was tax free), then the payments are taxed as pension or disability income.

Workers’ compensation.

Benefits payable from a workers’ compensation program are tax free (IRC section 104). They may effectively become taxable, however, if received in conjunction with SSDI, as described above.

SSI.

Payments under this program are tax free under the IRS’s administrative rule referred to as the general welfare doctrine (see IRS Publication 525, Taxable and Nontaxable Income).

 

Seek Advice

Individuals with a disability may be eligible for various benefits. Tax professionals can provide guidance on the tax implications of SSDI and other disability benefits. It is often helpful to use professionals to secure SSDI benefits; studies show that those who pursue an SSDI appeal with professional assistance were three times more likely to be successful than those who do not (GAO-18-37, 1/8/18).

Sidney Kess, JD, LLM, CPA ,is of counsel to Kostelanetz & Fink. He is a member of The CPA Journal Editorial Advisory Board.

Aaron Moss, JD, is a disability attorney in private practice in Baltimore, Md., assisted with the preparation of this article. He previously worked as an attorney advisor-decision writer at the Social Security Administration.