As disability insurance attorneys we are not qualified to give any tax advice. Some disability claimants are taxed on the disability benefits that they receive each month. What happens when a disability claimant is approved for SSDI and then the disability carrier demands a repayment for the gross pre-tax disability benefits that have already been taxed? In this scenario the claimant is now being faced with having already paid tax on the disability insurance benefits and having to pay tax on the SSDI benefits as well.
We reached out to Gary Kaplan, a certified public accountant to provide some general information on this issue. If you have specific tax questions we suggest you contact an accountant.
Is there any tax relief for repayment of previously taxed disability payments?
Mr. Samson received monthly long-term disability benefits for 2.5 years (July 2008 – December 2010). Since he originally paid disability insurance premiums with pre-tax dollars, Mr. Samson’s disability benefits were taxable in the 3 prior years when he received the money. On January 1, 2011, Mr. Samson was finally awarded retroactive Social Security benefits for the 2.5 prior years. He is now required to pay the gross amount (i.e. before-tax) of disability benefits back to the disability insurance company, even though he already paid tax on those benefits.
Law And Analysis
Under Section 1341 of the Internal Revenue Code, if an item was included in gross income for a prior taxable year (years) because it appeared that the taxpayer had an unrestricted right to such item, a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item.
Tax treatment will occur in the tax year of repayment, and will depend on the amount repaid.
A. Repayment of $3,000 or less: The taxpayer must deduct the gross amount of disability income repaid in the current year as a miscellaneous itemized deduction on Schedule A, subject to the 2% of Adjusted Gross Income (AGI) limitation. Note that if the taxpayer does not itemize, or the repayment is less than 2% of AGI, there will be NO relief for taxes paid in any prior year.
B. Repayment over $3,000: There are two options available that can be used. One must compare the effects of treatment in both options; the taxpayer can use the one that results in the least overall tax effect:
- Current year treatment: Deduct the gross amount of disability income repaid in the current year as a miscellaneous itemized deduction, as described in (A) above.
- Prior year treatment: Recompute the tax for each prior year as if the disability income had not been reported that year. The difference between the recomputed tax and the actual tax can be claimed as a tax credit on the current year’s 1040.
Mr. Samson repaid $15,000 in 2011 that he previously included as income on his 2008 – 2010 income tax returns. He figures what his tax benefit would be under each available option:
- A 2011 miscellaneous itemized deduction: Net tax benefit = $3,400.
- The sum of credits for 2008, 2009 & 2010 recomputed income tax if disability income payments received were not included in taxable income in each respective years: Net tax benefit = $3,750.
Mr. Samson would choose option 2, which has the greater net tax benefit. He would enter $3,750 as a tax credit on his 1040 return for 2011.
Taxpayers who repay over $3,000 previously tax gross disability income can recoup up to all prior tax paid, depending if an itemized deduction or a credit for prior year taxes will result in the least amount of tax in the current year. Taxpayers repaying $3,000 or less in the current tax year can only recoup any prior tax paid if they itemize and the repayment is more than 2% of AGI.
This case study does not consider the tax treatment of Social Security disability payments, or other issues that may affect your particular situation. Tax planning for disability payments and other complex issues should be made with the help of an experienced tax professional.
If you have specific questions about tax issues related to disability insurance, Gary Kaplan can be reached at 866-643-3560 or by visiting his website at gkaplancpa.com.