Should Disability Insurance Be Pre-tax?

First, disability benefits can be pre-tax in a cafeteria plan and IS pre-tax for employers in the tax code. In a nutshell, when HR offers disability to employees, the employer chooses to take a tax deduction on it. Then, the employee will pay taxes on the benefit if and when it’s paid out. So, the current landscape is that if the benefit is tax free, the employee has to pay taxes on the proceeds if used. The reverse is true if it is not taken pre-tax, the proceeds, aka benefits, would be tax free.

With that in information out of the way, here is the problem and solution.

As Jan said, pre-tax disability is taxed. But this takes place when the employer writes off the taxes they provided for “fringe benefits” including disability. In most cases, the employer is going to take the deduction for the disability and thus the proceeds are taxed. This point is essentially the discussion.

So what should we do? As an employer, we pay 80% of benefits offered to employees, including disability. This means that when employees use the benefit, 80% of the benefit will be taxed. Unless they take the other 20% pre-tax through our flex plan, they will get 20% tax free. Catch that?

Basically, 80% of the benefit is taxed when employees use it and 20% is not. At least that is how it is supposed to be reported to the IRS. We tell employees it is administratively better to take the 20% pre-tax so it’s consistent with the 80% taken pretax by the employer.

We could say to employees that we will still pay 80% of the benefit and NOT take disability as an employer tax write off. In this case, it’s better NOT to take the 20% tax free through the flex plan so that disability benefits are consistently not taxed by employer or employee.

Now, what if the disability is totally voluntary? Should employees be allowed to take disability pre-tax through the flex plan even though the benefit would be taxed? Some HR folks will make the decision for their employees not to allow voluntary disability to be tax free. But, that decision is contrary to the concept of cafeteria plans which offers a choice between tax free benefits and non-tax free. So, education is key. Statistics show disability usage is low. Chances are that it’s best to get a 20% discount on disability premiums through a pre-tax flex plan.

Hope this information helps.