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Group Disability Tax Group disability tax An overview and resource handbook for employers and their HR professionals MK-1984 (6-10) Contents: Unum: Your benefits partner 3 What tax rules apply? At Unum, we understand that employers design their benefit plans with diverse objectives and 4 Funding the disability plan goals in mind. The design choices they make can affect whether premiums and benefits are taxed, 5 Employer funded non-contributory and change the post-tax value of the benefits and gross up plans paid to their employees. 6 Combination funding To help you understand these tax implications, this handbook provides a general overview of the 8 Tax choice plans federal income tax rules that apply to disability plans. Various design options are outlined, along 9 Evaluating tax choice plans with helpful tools and checklists, so you can better align your benefit plan design with specific tax 10 LTD plan cost comparisons planning objectives. Whatever your objectives and goals, we will help 12 Selecting the right coverage design you meet them. 13 Summary: Group disability funding options 14 For more information 2 Group disability tax | unum.com Unum: Your benefits partner What tax rules apply? Federal personal income tax law can be summarized as three Disability insurance provides income basic rules: protection for individuals who cannot • Anything of value that an individual receives is income. work, or cannot work full time, due to • All income is taxable. injury or sickness. Unum provides a • Exceptions may apply. variety of disability products with a In this publication, we’ll focus on the exception that applies to taxing group broad range of coverage, cost and disability insurance premiums and benefits: premium funding options. • Premiums paid by the employer are not taxed as income to the employee. For certain business owners, benefits • Benefits are tax-free to the extent the employee paid premiums normally will be tax-free due to the tax with post-tax income. treatment of premiums attributable to This means that one way or another, the IRS always gets its money either as them. These business owners include: taxes paid on the money used for premium or as taxes paid on the benefits • Sole proprietors; when received. Simply put for employees with disability coverage: Tax me now or tax me later. • Partners; • S-corporation shareholders with more As you read further, keep in mind that we’re focused on how federal, not state, than 2% ownership interest; and income tax rules work generally for employees. As always, you’ll want to consult with your professional advisors when designing and administering your insured • Members of limited liability disability benefit plans. Doing so will enable you to comply with federal and corporations and limited liability state requirements, unique situations and special rules. partnerships. 3 Funding the disability plan When offering insurance benefits, the most fundamental Post-tax funding consideration is how to pay for the insurance coverage. Premiums are paid by the employees using payroll There are three possibilities: deductions after taxes and withholdings have been taken, or the employer funds and reports the premiums as taxable Pre-tax funding wages on the employees’ W-2s (grossing up the employees’ Premiums are paid by the employer or by employees income). Gross up plans are described in more detail in the through a cafeteria plan (even with funds designated by the next section. employee) and not reported as income on employees’ W-2 Result: Tax me now. Income taxes are paid on the premium Wage and Tax Statements. Employers use cafeteria plans dollars so benefits paid to employees will be tax-free. (also called salary reduction plans, or 125 Plans because Section 125 of the IRS Code applies to them) to fund Combination funding qualified employee benefits, including disability insurance. Premiums are paid with a combination of pre-tax and With cafeteria plans, employers provide employees with the post-tax dollars. opportunity to pay premiums on a pre-tax basis. This saves employees from having to pay taxes out of current income but Result: Partially tax me now. Partially tax me later. causes disability benefits that may be paid later to Income taxes aren’t paid on a portion of the premium dollars, be taxable. so a portion of any benefits received will be taxable but the remainder will be tax-free. For information on calculating the Result: Tax me later. No income taxes are paid on the taxable portion, see page 6. premium dollars so any benefits paid to employees will be taxable. Employers have the flexibility to apply one of these funding approaches across all employees or select different funding models for different classes of employees. For more information on who can constitute a class, see Combination funding (page 6). Take a look at the chart below for some typical disability plan types. Then read on to learn more about some of these plan design options and the steps employers need to take to achieve their tax planning goals. Particular attention is given to employer gross up, combination funding and tax choice plans. Premium taxation Plan type Premium funding Benefit taxation during year of claim Non-contributory Employer (100%) Pre-tax Taxable Employer gross up Employer (100%) Post-tax Tax-free Voluntary Employee (100%) Post-tax Tax-free Voluntary within a 125 Employee (100%) Pre-tax Taxable cafeteria plan Combination of pre-tax Traditional contributory* Employer and employee Partially taxable and post-tax Employer (base) and Combination of pre-tax Traditional base/buy up* Partially taxable employee (buy up) and post-tax Taxable, tax-free or partially Tax choice Employer, employee or both Depends on employee elections taxable depending on elections *These examples assume no gross up and no 125 cafeteria plan funding. However, more complex plan designs can include these funding options. For example, 4 grossing up the employer contributions will increase, and cafeteria plan contributions will decrease, the tax-free portion of any benefits paid. Group disability tax | unum.com Employer funded non-contributory and gross up plans As mentioned earlier, a significant exception to the federal Replacement ratios income tax rule that “all income is taxable” is that disability A gross up plan results in higher net after tax benefits for premiums paid by employers are not taxed to employees as claimants. In order to keep replacement income levels income. The employer pays the premiums without reporting consistent with employee expectations and to save premium them as W-2 income to the employees. This is the traditional, costs, employers might decide to reduce plan benefit employer-paid, non-contributory model. percentages. For employers interested in increasing coverage, Result: Tax me later. Any benefits received will be taxable. however, adopting a gross up plan may be a more cost effective way to increase benefits than increasing net Some employers who fund coverage want their employees to benefit percentages. receive tax-free benefits. With proper planning, employers can provide employees with tax-free benefits using an alternative Increased taxes tax treatment for employer-paid premiums called a gross up. Increasing W-2 wages can increase income, FICA and Medicare The election is made by the employer, and employees do taxes for employers and employees. not have a choice. Under a gross up plan, the employer pays premiums and reports those premiums as taxable income on Claims experience the employees’ W-2s. A gross up plan can impact claims experience and premium rates. Early consultation with your insurance representatives Result: Tax me now. Any benefits received will be tax-free, can mitigate these impacts. if the plan was properly designed and administered. As you can see, a gross up plan can create an economic Employee compensation advantage for employees while sick or injured. The offsetting A gross up plan results in higher reported income to disadvantage is that the premiums added to employees’ employees, so employers need to consider the impact to other income are subject to income taxes and employment taxes, compensation features such as bonuses and retirement plan adding to front-end tax obligations. Some employers elect to contributions. increase wages enough to cover their employees’ share of As an alternative to these employer-mandated gross-up plans, estimated increased taxes, but in other situations a gross up employers can give employees the option to choose whether plan does expose employees to marginally increased to be taxed on premiums paid or benefits received. When an tax liabilities. employee can choose a premium gross up, it is considered a Of course, there are rules and limits on employer gross tax choice plan, which is discussed later in this handbook. up plans. Here is a list of considerations for employers contemplating creating a gross up plan. Plan documents The employer must amend its benefit plan to expressly include employer gross up in the design and must communicate the plan design change to employees. Timing the plan change The plan change must be made prior to the start of the plan year to be fully effective for claims occurring in that year. Class choices The employer may offer a gross up plan to a class of employees, selected classes of employees or all employees. See Combination funding for more detail. 5 Combination funding As you’ll recall, when premiums are taxed, benefits are tax-free. When premiums have not been taxed, benefits are taxable. But what happens with combination funding, where only some of the premiums have been taxed? With combination funding, a sick or injured employee will have to pay taxes on a portion of any benefit payments received. A complex set of requirements governs how that portion is determined for group plans. These requirements (often referred to as the three-year look back rule) direct employers to calculate a taxable percentage reflecting the relationship between the amount of pre-tax premiums paid and the total premiums paid while looking back over as many as three prior policy years.
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