When are group disability benefits considered to be tax-free to the insured?

Tax-Exempt Conditions for Group Disability Insurance Benefits

Group disability insurance benefits are generally included in the policyholder's gross income and may be subject to tax. However, there are specific conditions under which these benefits may be tax-exempt:

1. Premiums Paid by the Individual

  - If the policyholder pays the disability insurance premiums with after-tax dollars (i.e., the premiums are not deducted from their gross income), then the benefits received from the policy are typically not taxable.

2. Employer-Paid Premiums

  - If the employer pays for the disability insurance premiums on behalf of the employee and includes the cost of the premiums in the employee's gross income, then the benefits received may be tax-exempt for the employee.

3. Interest Component

  - It's important to note that while the actual benefits might be tax-exempt under certain conditions, any interest received on the benefits is taxable. The policyholder should report this interest as income.

4. Transfer for Value Rule

  - If the policy was transferred to the policyholder for valuable consideration (other than to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer), the exclusion from income for the proceeds is limited. The tax-exempt amount cannot exceed the sum of the consideration paid by the policyholder, additional premiums paid, and certain other amounts.

5. Reporting Requirements

  - The taxable amount of the benefits is generally reported based on the type of income document received, such as Form 1099-INT for interest or Form 1099-R for distributions from pensions, annuities, retirement or profit-sharing plans, IRAs, insurance contracts, etc.

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Sources:

Publication 525 (2023), Taxable and Nontaxable Income 2024-08-03

Publication 17 (2023), Your Federal Income Tax - Internal Revenue Service 2024-07-29

2023 Publication 525 - Internal Revenue Service 2024-08-02

Instructions for Form 1120-L (2023) | Internal Revenue Service 2024-08-02

Part I: Background on Exempt Organizations’ Insurance Activiti 2024-08-02

Any disregarded entity, domestic, or foreign organization Taxable ... 2024-08-02

2023 Publication 17 - Internal Revenue Service 2024-07-31

Publication 575 (2023), Pension and Annuity Income 2024-08-03

Internal Revenue Bulletin: 2023-33 | Internal Revenue Service 2024-07-30

Life Insurance & Disability Insurance Proceeds - Internal Revenue Service 2024-08-01