Originally published on Forbes.com.
The Tax Court has characterized the taxation of disability income as “curious and somewhat confusing.” I would also say it is unfair and that it is really not possible to discern any public policy rationale behind the system. What I notice most is people being blindsided and, in some cases, experiencing marginal income tax rates that are beyond confiscatory on relatively modest payments.
Tax complexity is always unfortunate, but often unavoidable, the result of an arms race between too clever planners and regulators cleaning up behind them. When restricted to high finance, it is not such a bad thing, being a sort of white-collar jobs program that requires the very wealthy to support a slice of the upper-middle class. Tax complexity that people can’t afford to pay for is another matter. And that is what you have with disability income.
Different Types Of Disability Income
To start out I need to mention that I am not going to discuss military/veteran payments which have their own complications. With that qualification, there are four types of disability income you might receive, each with its own profile. If you collect on a disability policy that you paid for with after-tax dollars, the proceeds are not taxable. If you collect on a policy paid with pretax dollars or employer contributions, it is taxable. Workers’ compensation payments are not taxable. And then there is social security disability income. SSDI had the same tax profile as social security retirement benefits. A dollar of social security benefits is never fully taxable. It can be exempt or either fifty cents or eighty-five cents can be taxable. It depends on how much you received in the year and how much other taxable income you have.
Generally speaking, someone who only has negligible other income will not be taxable on any social security. Unless they get a big lump sum from social security. The big lump sum is what happens to people who are turned down for SSDI, appeal, and win their appeal. What can be really bad for somebody in that situation is that there might not be much, if any net, since there might have to pay back previously collected private disability payments? That was the pickle that Michael Nordloh, whom I wrote about last week, found himself in.
From A Disability Expert
Thanks to that post, I heard from Attorney Michael Bertics. Mr. Bertics is a Board Certified Workers’ Compensation specialists and chairs the North Carolina State Bar’s Specialty Committee on Workers’ Compensation. He laid out for me a scenario which was much more dire.
Consider the case of an individual who becomes disabled due to a work injury that the workers’ compensation carrier denies. The individual first becomes eligible for taxable LTD benefits. Then after a few years, Social Security approves SSDI benefits. This triggers the LTD repayment right referenced in your article, with corresponding tax issues. Typically, SSDI benefits are less than the entire LTD benefit under most plans. If workers’ compensation benefits are subsequently awarded, the poor individual is then hit with a dual repayment obligation (first to Social Security due to SSDI offset, and then to LTD for the remainder of the LTD benefit left over after the prior repayment following SSDI approval). Social Security still issues folks tax forms even when the SSDI payments are offset due to the receipt of WC benefits. If the unfortunately individual had their spouse apply for a spousal benefit, the SSDI offset becomes dollar for dollar. Thus, the poor individual may end up having repayment obligations to SSDI and LTD that exceed the amount of the WC award because both SSDI and LTD have their hands out for the same WC dollars. At the same time, both the LTD carrier and SSA issued tax forms as if they were not offsetting the benefits based on subsequent WC payments.
The end result can be a lot of phantom income for tax purposes as well as significant repayment obligations that can exceed the whole of the WC award.
The fact that the IRS taxes folks on SSDI benefits they don’t receive due to WC offset is a terrible injustice.
More Can Be Less
I spent some time talking to Mr. Bertics. He emphasized how an SSDI recipient can end up harming himself by getting family benefits, because of the way workers compensation offsets interact with the SSDI. He also said that try as he might there is a limit to how much tax help he can give his clients beyond referring them to IRS Publication 951. As I suspected the scattered Tax Court decisions I have seen on these issues are the tip of an iceberg of a problem of confused taxpayers blindsided by not very logical tax rules. And even though the dollars can be very significant to the disability recipient, they are not significant enough to interest a tax attorney or even most preparers. You see a similar situation in the divorces of the less than rich and famous where divorce attorneys can produce less than optimal tax results or ignore important details.
Michael Nordloh’s not terribly complicated situation yielded four different answers, one from an Enrolled Agent, one from a CPA, and two different answers from the IRS, which still tried to hit him with an accuracy penalty.
The practical takeaway from this discussion is that if you have the prospect of receiving disability income, be sure to consider the tax effects of the different choices you make. A few extra dollars from SSDI might end up putting you in a net negative situation. The tax rules here kind of scream for simplification, but I have not seen any reform proposals being floated sticking you with Reilly’s First Law of Tax Planning. It is what it is. Deal with it.