Can self employed deduct disability insurance premiums

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IS DISABILITY INSURANCE TAX-DEDUCTIBLE?

Many of my clients ask me the popular question: is disability insurance tax deductible? It may be a little complicated, but the real answer is maybe. It all depends on who provided the coverage and what type of business you own.

Even if they are tax-deductible, it may not be in your best interest to take that deduction. Why? Because if you did, the benefits would be taxable. If you pay with after-tax dollars (not deductible), the benefits would be received tax-free.

Unlike other health insurance (which disability insurance is technically classified as), you typically cannot deduct the premiums on your tax return. But because the premiums are paid with after-tax dollars, the benefits would be received tax-free during a claim.

Let's look at business owners to see if they can take a deduction for the premiums:

1. Sole-Proprietor - A sole-proprietor is the sole owner of a business. Sole proprietors usually file a schedule C (which is where the tax deductions are taken). The issue is that sole-proprietors are not considered employees, but self-employed; thus, the premiums are not tax-deductible. The benefits would be received tax-free.
   
2. Partnerships - The income from a partnership is not federally taxed and income (or loss) flows to the partners who are taxed based on their proportionate share of the profits of the partnership. Although the partnership can deduct the premiums paid to the partners as a guaranteed payment, the premiums are included in the partner's income. This means that although the partnership was able to make a deduction, the partner would be paying tax on the premiums. The benefits received would be tax-free.
   
3. S-Corporation - Is taxed very similarly to a Partnership whereas the corporation does not pay federal tax and the income (or loss) is passed to the shareholders on a proportionate basis. The laws allow an S-Corporation to deduct the premiums, but if the owner owns more than 2% of the shares, the premiums are included in his/her income, making the benefits tax-free. In essence, with both a Partnership or an S-Corporation, the premiums are deducted by the business, but the premiums are included as income, so it is really a wash to the shareholder/partner and benefits are received tax-free.
   
4. C-Corporation - C-Corporations are separate legal identities that file their own tax returns and pay their own tax. If you are a shareholder and also an employee, the corporation can deduct the premiums. If they do, the benefits received would be taxable. There can also be cost-sharing where the corporation pays the premiums and the employee/shareholder is taxed on part of the premiums. In that case, the percent of premiums that the shareholder pays taxes on would be received tax-free. For example, if the premiums for shareholder X are $3,000 annually and the shareholder elects to include $1,000 in his taxable income, then he would receive one-third of the benefits tax-free.

Many employers offer group disability insurance to their employees. Most of the time, the premiums are paid entirely by the employer and the benefits received are taxable to the employee. Some companies offer the employee the option to pay all or some of the premiums with after-tax (not deductible) dollars or to include the premiums on their W-2. In this case, the portion of the benefits that are paid for with after-tax dollars is not taxable, and the other portion that is paid for by the employer only would be taxable.

Let's look at an example. XYZ Corporation provides employee Y disability insurance benefits with an annual premium of $1,000.

• Scenario 1. The entire premiums are paid for by XYZ Corporation- The benefits received would be taxable to employee Y.
  
• Scenario 2. The entire premiums are either paid for by the employee or included in their W-2 at the end of the year- The benefits received would be tax-free.
  
• Scenario 3. Half of the premiums are either paid for by the employee or included in their W-2 at the end of the year. Half of the benefits received would be taxable and the other half tax-free.

As discussed above, it may not be in your best interest to take a deduction for disability insurance, even if you could. If you never become disabled and never collect benefits, then obviously it would have been a better choice to take the deduction. The problem is no one knows what the future holds. If you did become disabled, then you would have probably been much better off not taking the deduction since the benefits would have been received tax-free.

Let's look at an example of a 35-year-old attorney with a $5,000 monthly benefit, cost-of-living rider, and an annual premium of $1,500.

• If that person became permanently disabled soon after the purchase of the policy and remained disabled until age 65, the potential payout would be about $2,800,000. If he is in a 25% tax bracket, he would have paid over $700,000 in taxes on the benefits, if he was able to, and deducted the premiums on his taxes.
  
• If he did not, the entire $2,800,000 would have been tax-free. If he was in the same 25% tax bracket, took the tax deduction, and never became disabled, he would have saved about $11,250 in taxes ($1,500 annual premium times 30 years times 25% tax bracket). Is it really worth the small savings to pay a potentially huge tax in the future?

So, is disability insurance tax deductible? Again, maybe, maybe not.

Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. The information provided is based on our general understanding of the subject matter discussed and is for informational purposes only. All scenarios and names mentioned herein are purely fictional and have been created solely for educational purposes. Any resemblance to existing situations, persons, or fictional characters is coincidental. The information presented should not be used as the basis for any specific investment advice.

2024-175176 Exp: 5/30/26