Long-term disability coverage at open enrollment: should premiums be pre-tax or after-tax?

Paying long-term disability premiums before tax can make your eventual benefit taxable. Here’s how the break-even math works and which box to choose at enrollment.

Your open enrollment form may include a long-term disability option, along with a choice many people overlook: pay the premium before tax or after tax. That single checkbox determines whether the benefit you receive on a financially difficult day will be taxed. The rule is simple, and the math is easy to estimate.

Who pays the premium determines who pays the tax

The IRS taxes disability benefits based on who paid for the coverage.

If you pay the full premium with after-tax dollars. The benefit is generally not taxable, and you do not report it as income.

If you and your employer share the premium. Only the part of the benefit tied to your employer’s contribution is taxable.

If you pay through a cafeteria plan and the premium comes out of your paycheck before tax. The IRS treats those premiums as employer-paid, which means the full benefit is taxable.

That final scenario is the catch. Pre-tax contributions are often the default elsewhere in a benefits package, such as with a 401(k), an HSA, or a commuter account. Here, however, pre-tax treatment quietly turns a tax-free payout into a taxable one.

Why the benefit matters more than the premium

Disability coverage is less common than many workers assume. In one recent March survey, 44 percent of private-industry workers had access to short-term disability plans and 37 percent had access to long-term plans.

Social Security does not fully close the gap. Disabled workers received an average monthly benefit of $1,636.47 in a recent September snapshot. To qualify, the condition must have lasted, or be expected to last, at least 12 consecutive months and must prevent the person from working at the substantial gainful activity level.

If a disability resolves after seven months, Social Security may pay nothing. In that case, your employer’s plan may be the only protection between you and your savings.

The math: a three-month test

Consider an example employee earning $72,000 a year, or $6,000 a month. If the plan replaces 60 percent of pay, the monthly benefit would be $3,600. Your own plan may differ, so check the summary plan description.

Assume the premium is $45 a month, or $540 a year. The real amount may be different; use the figure in your enrollment materials.

Now assume a combined federal and state tax rate of 15 percent.

If you pay pre-tax. The $540 premium is deducted before tax, so you save $81 a year in taxes. Over 20 years, that adds up to $1,620.

If you later receive benefits, those payments are taxable. The tax on one month of benefits would be $540, based on the example rate.

If you pay after-tax. You give up the $1,620 in premium-tax savings, but a future claim would not be taxed.

Divide the $1,620 in premium-tax savings by the $540 monthly tax on a claim, and the break-even point is three months. If you collect benefits for more than three months over the life of the policy, the after-tax option comes out ahead.

The tax rate itself does not change that conclusion. Whether the rate is 10 percent or 32 percent, the premium savings and benefit taxes rise or fall together, so the break-even point remains three months as long as the tax rate is the same when you save and when you collect. The formula is annual premium times years, divided by monthly benefit: =(45*12*20)/3600.

To calculate your own break-even point, you need three numbers: your monthly premium, your monthly benefit, and how long you expect to keep the coverage.

When pre-tax can still make sense

There is one important wrinkle that can favor the pre-tax choice. If you become disabled, your income may fall, and the tax rate on the benefit could also drop. For example, if the tax rate on that benefit fell to 5 percent instead of 15 percent, the monthly tax would be $180. In that case, the $1,620 premium-tax savings would equal nine months of claim payments.

Nine months is still a lengthy claim. And the real decision is not whether you will need the coverage, but which version of the claim you would rather receive.

If your employer pays the full premium, you do not get to choose, and the benefit will be taxable. A plan that replaces 60 percent of pay but is taxed will leave you living on less than 60 percent of your salary, so your emergency fund and budget should be built around that smaller amount.

Three questions to ask HR before enrollment ends

Ask whether the premium is taken out pre-tax or after-tax. Ask whether you can change that choice, and when. Some plans lock the election until the next open enrollment period, so one wrong checkbox can follow you for a full year.

Then review the plan summary for the benefit percentage, the waiting period before benefits begin, and the plan’s definition of disability.

The choice to make

If your plan gives you a choice and you depend on your paycheck to cover household expenses, after-tax premiums are usually the safer option. The pre-tax discount only buys roughly three months of claim protection; after-tax treatment preserves the rest.

If you have enough savings to cover years of expenses without income, pre-tax premiums may be acceptable, or you may decide to skip the coverage altogether. If your employer pays the full premium and there is no election, there is nothing for you to change; instead, plan for a taxable benefit. If you own an individual policy that you pay for yourself, the premiums are already after-tax, so this choice does not apply.

Sources

1. Internal Revenue Service, Life insurance & disability insurance proceeds
2. U.S. Bureau of Labor Statistics, Employee Benefits in the United States
3. Social Security Administration, Monthly Statistical Snapshot
4. Social Security Administration, How Does Someone Become Eligible? | Disability Benefits