Are Disability Insurance Premiums Tax Deductible? It Depends On How You Buy

Are disability insurance premiums tax deductible? A quick Google search will say the answer is no. But if you’re a business owner, the answer is more complex. In which case, a smarter question is: Should you deduct disability insurance premiums on your taxes?

Keep reading to learn when disability insurance premiums can be tax deductible and how to decide which course of action to take.

Are disability insurance premiums tax deductible?

Generally speaking, you can’t deduct disability insurance premiums on your tax return. However, if you own a practice or other business, you might be able to deduct the cost of disability insurance in certain cases.

The IRS specifically states you can’t deduct premiums for a policy that pays for loss of earnings due to sickness or disability. However, business owners can deduct premiums for overhead insurance designed to keep their business afloat during long periods of disability by covering rent, utilities, etc.

Additionally, business owners have the opportunity to provide disability coverage to employees, allowing you to then deduct the paid premiums as a business expense. But should you?

If you buy disability insurance as a company benefit (for yourself and your employees), you can deduct the premiums. However, in doing so, any disability benefits you receive are considered taxable income.

On the other hand, if you choose to buy disability insurance for yourself through an individual policy, you can’t deduct your premiums. But you’ll receive tax-free disability income, meaning you won’t have to worry about taxes during a time of financial and personal crisis.

Company benefit vs. individual policy: A question of tax preference

Our SLP Wealth clients are a mixture of W-2 employees, S-corps and partnerships — with many headed in the direction of self-employment. So, let’s break down how disability insurance is treated for tax purposes in each of these situations.

For employees: Choosing between pre-tax and after-tax premiums

If you're traditionally employed in a W-2 position, you won’t be able to deduct disability insurance premiums on your taxes. But you might be able to choose your preference in terms of whether you receive a tax benefit now or later.

If your employer gives you the choice, you should elect to pay your portion of the premium with after-tax dollars. This will require you to commit to giving up a small dollar amount now in return for a larger tax-free payout later.

Keep in mind that if you’re receiving disability benefits under an employer-sponsored plan, this implies you aren’t able to work. It wouldn’t be a great time to have to worry about an additional cash outflow in the form of income tax.

For S-corps and partnerships: Playing by a different set of rules

You generally can’t deduct disability insurance policy premiums that are paid for partners or owners. However, in some cases, the business can deduct the premium and report the payment as income to the partner or owner.

In either situation, the partner or owner is paying for the premium with after-tax dollars. Any received disability insurance benefits aren’t taxable.

To demonstrate, let’s say that Linda is a more-than-2% owner/employee of ABC, which is an S-corp. ABC offers group disability insurance to all its employees. The cost of protection for Linda is fully paid for by ABC and totals $2,000.

ABC can deduct the paid premiums and report the $2,000 as compensation on Linda’s W-2. In turn, if she becomes disabled, her disability benefits won’t be taxable.

Financial planning considerations for business owners

Business owners must consider the trade-off between paying premiums as the employer or providing employees with a bonus that can be used for premiums on individual coverage. This becomes super important when the employer chooses to offer disability insurance only to a select group of executives.

You need to look at which scenario is more beneficial for your employees and yourself as the employee/owner:

1. Covering the premium payment: While the employee pays no income tax on group disability insurance premiums paid by the employer, the disability benefits from an employer-paid group plan are taxable to the employee. If no disability occurs, the employee avoids taxes with the employer paying the premiums. However, if a disability occurs, the employee will have income tax on the benefits received.
2. Using the bonus plan: If you choose to provide a bonus instead, the employee must pay income taxes each year on any bonus. They won’t receive a deduction for paying the premiums on a disability policy, but the received disability income will be tax-free.

It comes down to whether you (or your employees) might prefer to receive a bonus and find an individual disability insurance policy separately. Or, instead, have a disability premium paid for, knowing taxes will come into play if a disability occurs.

How to decide whether to deduct disability insurance premiums on your taxes

As a business owner, you have to look at multiple angles in terms of what you want to do for your employees. But you’ll also need to factor in how you can benefit as well if you’re an owner/employee.

Let’s say an executive expects tax rates to rise in the future, putting her in a higher tax bracket later in life when disability is more likely to happen. Knowing this, she might favor receiving disability income tax-free, in which case providing coverage for all employees (including herself) might be attractive.

But what if the additional taxes from the bonus scenario could be alleviated by providing a double bonus plan that also pays the additional income taxes?

This double bonus amount can be calculated by dividing the premium by (1 – tax bracket). And in this case, the bonus approach might be more beneficial to her.

Real-world insights on deducting disability insurance premiums using a double bonus plan

Here’s an example of how the decision to deduct disability insurance premiums might play out with real numbers.

Let’s say the premium on an individual disability income insurance policy for Kate is $3,000, and she’s in the 35% tax bracket. Kate’s employer pays her a “double bonus” to cover both the cost of the premiums and the taxes generated by the salary bonus. Therefore, Kate’s total salary bonus is $4,615 ($3,000 / (1 – 0.35)).

With Kate's bonus of $4,615, the company has provided her with enough “additional” net income to purchase an individual insurance policy and pay the additional taxes due on the bonus.

The company also gets to deduct the full $4,615 as a compensation expense. Just keep in mind that Kate’s compensation has to remain “reasonable.”

Note that double bonuses generally do not help owners of pass-through entities — such as sole proprietorships, partnerships, and S-corporations — due to the flow-through of taxation. This strategy is still beneficial for non-owner employees, just not for the business owners themselves. However, owners of C-corporations are treated the same as other employees, so the double bonus works well for them.

When disability insurance meets tax strategy

Disability insurance carriers usually set a limit on the amount of disability insurance they issue for a given person. That limit includes disability insurance purchased for uses such as nonqualified deferred compensation, key person disability insurance, group disability insurance plans and individual disability policies. Strategy and timing are important.

For example, a small business owner who is also an employee of the business can typically obtain more coverage by purchasing an individual policy first and then adopting a group policy for the business. This is because disability insurance companies, like the “Big 5,” consider your group benefits when determining your coverage limits. By following this strategic timing, you could end up with more disability insurance coverage (i.e., more tax-free benefits) than the insurer would ordinarily issue for an individual — especially if the business structure is set up to benefit you.

Disability insurance is just one aspect of the holistic approach SLP Wealth takes for fiduciary financial planning. Get in touch with our team to learn more about our comprehensive financial and investment services.