Many applicants ask about whether to pay short-term disability premiums with before or after-tax payroll deductions. There is no single right answer. Each selection has pros and cons, which may affect people differently depending on their circumstances, and motivations for purchasing a policy.
To understand which premium option makes the most sense, consider the pros and cons of each deduction choice, and apply it to your personal situation.
- Advantages of before-tax elections
- Advantages of after-tax elections
- Applying elections to personal motivations
Short-Term Disability After-Tax Deductions
There are three primary advantages for paying premiums for short-term disability with after-tax payroll deductions are the reverse of the above: the claims payments come tax-free, and you have unlimited ability to begin or cancel your policy outside of an open enrollment period. The hidden advantage of making after-tax deductions is the ability to expand the level of income replacement.
Expanded Income Replacement
As mentioned earlier, most policies replace a portion of gross income – 66%. While working, we all have money withheld from checks to cover tax liabilities: federal, state, and FICA taxes. An employee in the 25% federal income tax bracket may have take-home-pay that is about 66% of gross income (25% federal taxes, and 7.65% FICA taxes).
A policy replacing 66% of income paid for with after-tax contributions equates to 100% of take-home income when you consider the net tax effect.
Expecting to use the Policy
It is better to choose after-tax when the applicant expects to use the benefit. This scenario arises most frequently with women purchasing short-term disability for childbirth. Applicants are planning to use the policy.
When purchased prior to conception, the policy covers normal childbirth, plus any complications. The claims paid for normal childbirth are often several multiples of the premiums paid in advance.
Many women want to start their policies outside of open enrollment to coincide the policy effective date with the time of conception. They also want to cancel their policies immediately after giving birth. Use of after-tax elections provides this flexibility.
However, one note of caution is warranted. Canceling your policy can be hazardous to your financial health! Not every employer offers voluntarily paid maternity leave options. If you change employers, you may not be able to purchase a replacement policy.
Applying Elections to Motivations
My favorite question to ask applicants when they are pondering whether to choose before or after-tax payroll elections for short-term disability is, “Would you rather pay taxes on a small amount of income or a larger amount of income?” Most respond that they would rather pay taxes on the smaller amount.
The premium is the smaller amount when the policyholder expects to use the policy. When there is greater uncertainty about whether the applicant will use the policy in the future, then the benefit is the projected smaller amount.
Short-Term Disability Before-Tax Deductions
When making premium payments using before-tax payroll deductions there are immediate tax savings, but the future, uncertain claims payment becomes income taxable. The insurance company may issue a 1099 statement showing the amount of claims income received during the year, and the recipient pays taxes on the amount. So, which option is best?
There are two primary advantages, and one important disadvantage for an employee to make short-term disability insurance premium payments using before-tax payroll deductions: immediate certain tax savings, greater tax efficiency, and open enrollment limitations.
Immediate Certain Tax Savings
Immediate certain tax savings is the primary advantage of almost any pre-tax payroll deduction. Making short-term disability insurance premium payments is no different. Before-tax payroll elections lower your reportable w2 income. Policyholders realize immediate savings on federal income taxes, FICA taxes, and state income taxes (except in New Jersey).
These savings are certain. Policyholders know what the premium costs are, and can reasonably estimate what the tax savings will be.
Open Enrollment Limitations
The primary drawback to making short-term disability before-tax elections is the loss of election flexibility. Cafeteria plans allow changes to pre-tax elections only during an employer’s open enrollment period. Your policy can only commence on your employers’ plan year anniversary date, and you can only cancel your policy during the open enrollment.
Greater Tax Efficiency
Most short-term disability policies replace a portion of income in the event of a future loss of income, due to a covered medical condition. That means two things important to our question: your marginal tax rate may be lower, and the event is uncertain.
Most policies will cap benefits at 66% of gross income. That means at the time of claim the policyholder has a lower income. Both state and federal income tax tables are progressive. As income rises, the marginal tax rate climbs in tandem. If you become lose income while unable to work, you may be in a lower income tax bracket.
Medical events are by definition uncertain future occurrences. Many people buying short-term disability hope never to make a claim. You can logically discount the tax consequences of an event that may never happen.
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