What is a disability?
The dictionary defines a “disability” simply as a physical or mental condition that limits a person’s movement, senses, or activity. However, disability income programs and tax laws define disability differently for different purposes.
The Social Security Administration defines disability as the inability to engage in substantial gainful activities (SGA) due to a medically determinable physical or mental impairment that has continued for at least one year, or is expected to continue, or result in death.
A child under the age of 18 is considered disabled if he or she has a medically determinable physical or mental impairment that significantly limits their activities. Such condition must have lasted or be expected to last for at least one year or result in death.
The Social Security Administration has two programs that may be available to individuals who meet the SSA’s definition of disability: Social Security Disability Insurance (SSDI) and Supplemental Security Income (SSI).
SSDI is a federal program funded by payroll taxes that protects workers from severe disabilities. SSDI is available to individuals who have a medically determinable disability that limits their ability to work at a substantial gainful job if they have not yet reached full retirement age to qualify for a Social Security pension. SSDI does not depend on an individual’s financial situation. To qualify for SSDI, an individual must be “insured” for Social Security benefits. Generally, this means that an individual must have worked for at least 5 of the past 10 years before becoming disabled by a serious physical or mental impairment that lasted or is expected to last at least one year, or that resulted in death. Only about 50% of applicants are medically determined to be eligible for SSDI.
SSI is a means-tested government program for disabled adults and children whose income and assets fall below certain thresholds. SSI is also available to non-disabled individuals age 65 and older. (SSI benefits are paid from general tax revenues, not from Social Security taxes.)
The Social Security Administration uses the same definition of disability for both SSDI and SSI.
Definition of disability that is an exception to the 10% early distribution penalty.
Anyone taking a distribution from a qualified retirement plan or IRA before age 59 1/2 is subject to a 10% penalty, unless they are disabled. [IRC section 72(m)(7)]The definition of disability for this purpose is the same as the Social Security disability definition: an individual is considered disabled if he or she is unable to engage in substantial gainful activity because of a medically determinable physical or mental impairment that is expected to result in death or to continue for an indefinite period of time.
Definition of disability that qualifies an “eligible designated beneficiary” for required minimum distributions (RMDs).
Individuals who inherited a retirement account from a decedent who died after 2019 are subject to the 10-year distribution rule unless they were a “qualified designated beneficiary.” A designated beneficiary is eligible for this designation if they are disabled. Under the proposed regulations (NPRM REG-195954-20, February 23, 2022), if the designated beneficiary was under 18 years old when the account owner died, the designated beneficiary must have a “medically determinable physical or mental disability that results in a significant and severe functional limitation and is expected to result in death or be for an indefinite period of time.” If the designated beneficiary is older, the definition of disability is the same as that used for early distribution penalty purposes (i.e., inability to engage in substantial gainful activity). There is also a safe harbor that uses Social Security’s definition of disability, which includes chronic illness.
Definition of disability in workers’ compensation.
Employees who suffer a work-related injury or illness may be eligible for workers’ compensation benefits. If an employee does not fully recover but their condition is stable (i.e., “permanent and stable”), permanent disability benefits are paid.
Definition of disability for commercial (private) disability insurance.
The definition of disability in private disability insurance is set by the terms of the contract and depends on whether the insurance is for short-term or long-term coverage. For example, benefits may be paid even if a person is able to continue working.
How are disability benefits taxed?
Tax treatment varies depending on the type of disability benefit.
Social Security Disability Income.
SSDI is treated exactly like a Social Security pension. Benefits are tax-free or includible in gross income at 50% or 85%, depending on the individual’s other income (IRC section 86). More specifically, benefits are includible in gross income if 1) half of the benefit and 2) the sum of all other income, including tax-free interest, exceeds the base amount for the person’s filing status. The base amount is $25,000 for singles, heads of households, qualifying widows, and separated couples if the taxpayer lived apart from their spouse for the entire year, $32,000 for married filing jointly, and $0 for married filing jointly. Married filing jointly must combine their income and Social Security benefits when calculating the taxable portion of the benefit.
Individuals who qualify for SSDI can receive their “back pay” in a lump sum. Disability benefits begin only five months after the Social Security Administration’s disability start date. However, the maximum period eligible for retroactive payments is 12 months prior to the date you applied for SSDI. An amended return is not used to report the payment, even if the back pay relates to a prior year. The payment is reported on the return for the year it was received. However, taxpayers have the following options for the amount to include in their income:
You choose to use your current year earnings to calculate the taxable portion of the total benefit you received in the current year, or use your current year earnings to calculate the taxable portion of the prior year’s lump sum. More information about this option is provided in IRS Publication 915, “Social Security and Equivalent Railroad Retirement Benefits.”
Workers’ compensation benefits reduce SSDI [IRC section 86(d)(3)]Workers’ compensation benefits are not taxable, but to the extent they reduce SSDI, they are effectively included in gross income to the extent described above.For example, because workers’ compensation payments may be effectively taxable, a taxpayer may be better off after-tax by not claiming SSDI (see John C. Thompson, TC Summary Opinion 2016-20).
Disability pension.
Disability pensions are taxed as salary until retirement, and if payments continue thereafter, they are taxed as pension income.
Payments from commercial disability insurance.
If premiums for private disability insurance are paid with after-tax amounts, the benefits from the insurance are tax-free (IRC section 104). If premiums are paid with pre-tax amounts (for example, if the employer pays the premiums and treats them as a nontaxable employee benefit, or if the employee pays the premiums through a tax-exempt cafeteria plan), the payments are taxed as pension or disability income.
Workers’ compensation.
Benefits paid from workers’ compensation plans are tax-free (IRC section 104), but if received in conjunction with SSDI as described above, they may be effectively taxable.
SSI.
Payments under this program are tax-exempt under an IRS governing rule called the General Welfare Principle (see IRS Publication 525, “Taxable and Nontaxable Income”).
Ask for advice
People with disabilities are eligible for a variety of benefits. A tax professional can advise you on the tax implications of SSDI and other disability benefits. Using an expert is often helpful in securing SSDI benefits. Studies have shown that people who file SSDI appeals with the assistance of an expert are three times more likely to be successful than those who do not (GAO-18-37, 1/8/18).