Disability, whether short or long term, can happen to anyone at any time. While that’s bad enough, most people find out – usually at the most inopportune time – that their benefits aren’t nearly as generous as they believed. Not because of the terms of their group policy, however, but because of taxes!

Not too many years ago, most employers offered group long-term disability coverage, with employees purchasing short term coverage outside of the company environment, or going without. Nowadays, its more the norm for an employer to offer both short and long term coverage for all employees. Many employees think this is a great deal; the reality is that it may not be. When they become disabled, the IRS steps in and determines who paid the premium – and if the premium was paid with dollars from the employer, the employee must then report the disability benefits as wages, subject to taxes.

Depending on the different types of policies, the tax rules can vary as well. For instance, short term disability payments generated by employer premiums are subject to Social Security tax, in addition to taxation as ordinary income. Employers might be liable for this tax, as well.

Long-term disability premiums paid for by the employer will not incur Social Security taxes, due to the longer waiting period for benefits to start. However, they are subject to taxes as ordinary income by the federal government.

Most employees would prefer to receive their disability benefits on a tax-free basis, especially since it is common for expenses to go up, not down, in the event of a disability. By guaranteeing that premiums for disability coverage’s are paid with taxed dollars, employers’ preserve the benefits their employees expect.

The simplest way for an employer to do this is to set up a plan properly in the beginning, with good employee communication, and a clear understanding of the risks inherent in relying upon employer-paid disability plans. Often, employees will opt for an employee-paid plan, even if the coverage is mandatory, once the risks are explained. Employee salaries can be adjusted to compensate for the after-tax payment of disability coverage, for instance.

For executives, individual list-bill disability policies can be bonused for costs plus taxes, thereby giving the employer a tax deduction while preserving the tax-free advantage of individually-owned disability plans.