If you suffer some disabling ailment or injury, you'll be glad to have disability pay coming in. However, it's important to understand that the IRS -- and your state -- may want to take a cut of that pay. Some sources of disability pay will be taxed as income, while others are completely tax-free, and still others may or may not be taxed depending on the situation.
Social Security disability benefits
If you have a qualifying disability, you may start receiving Social Security disability benefits long before you're eligible for retirement benefits. Social Security disability becomes taxable under the same circumstances that Social Security retirement benefits do. In brief, if you file a joint tax return with your spouse and your taxable earnings plus half your Social Security benefits add up to more than $32,000 per year, your benefits will be partially taxable. If you're single or married filing separately, the threshold is $25,000. Depending on your income, up to 85% of your Social Security disability pay may be subject to federal taxes.
Most states do no levy a Social Security tax, but the following 12 do: Connecticut, Colorado, Iowa, Kansas, Montana, Minnesota, Nebraska, North Dakota, Rhode Island, Utah, Vermont, and West Virginia.
Short-term disability benefits
Short-term disability insurance pays employees a percentage of their normal salary if they miss work for more than a few days because of illness or injury. Five different states require employers to provide a short-term disability plan for employees (though companies in other states may offer plans at their discretion): California, Hawaii, New Jersey, New York, and Rhode Island. Short-term disability benefits from California and Rhode Island are not subject to federal income taxes, because the payments for these disability programs come from the employee's paycheck, not from the employer. However, the programs in the other three states are partially funded by employers, so the benefits are partly subject to federal taxes.
As for state-level taxes, California, New Jersey, and Rhode Island do not tax short-term disability benefits, but Hawaii and New York do. If you live in a state that doesn't provide state-sponsored short-term disability, you can buy such a plan from a private insurance company. In that case, if you pay all the premiums yourself from after-tax dollars, then the benefits are not taxable; if you and your employer share the cost of the premiums or you pay them from your paycheck using pre-tax dollars, the benefits will be partially taxable.
Long-term disability benefits
Many employers offer their employees the option to purchase a long-term disability insurance plan. These plans kick in after a waiting period once an employee becomes disabled and will pay the employee a percentage of their salary either for a set length of time (say, two years) or until the employee retires. As with private short-term disability benefits, the long-term benefits will not be taxable if you paid the premiums yourself with after-tax dollars. However, if you and your employer shared the cost of the premiums, the benefits will be partially taxed.
Other types of disability benefits
Under certain circumstances, you may be eligible for more specialized disability benefits with a variety of tax treatments. For example, disability benefits from Worker's Compensation are not taxable unless you return to work while continuing to receive benefits, in which case the benefits would become taxable. Military disability pensions are taxable unless your disability is due to injury or illness received during active duty, in which case they may be tax-free. And if your disability makes you eligible for Medicare, you can deduct any Medicare premiums you pay as a medical expense on your federal tax return -- and the benefits themselves are not taxed.
If you're receiving disability benefits through such a specialized program, you may want to consult a tax professional with experience in disability taxation to be sure that you're paying any necessary taxes. That will help you avoid the unpleasant experience of paying penalties and interest to the IRS and possibly your state revenue board as well.