Going on disability is a lot more common than you might think. The Social Security Administration says 1 in 4 people in their 20s will become disabled before reaching retirement age. Disability can come from injury or illness and can be short-term or long-term, so it's smart to think about the financial impact. One concern is the tax treatment of disability benefits. Whether they count as earned or unearned income is a key question.
Some employers offers short-term disability benefits that pay you some or all of your wages while you're temporarily unable to work. The Internal Revenue Service considers those payments earned income -- the same as money earned on the job. If you suffer a disability that leaves you unable to work entirely, long-term disability benefits provided by an employer will be considered earned income until you reach retirement age. This is true even if you have to "retire on disability." Once you hit retirement age, though, the IRS looks at such payments like a pension, which is unearned income.
If you get benefits from a disability insurance policy, the IRS classifies your payments based on who paid the insurance premiums. If you paid the whole cost of the premiums out of your pocket, as with a private policy, your benefits aren't considered earned income. In fact, you don't report those benefits as income at all; insurance payments are generally untaxed. Some employers offer their workers a supplemental disability insurance policy, in which you and the employer split the cost of your premiums. In this situation, the part of your benefits that your employer paid is earned income -- which means it's taxable. If the employer paid 70 percent of the premiums, for example, 70 percent of your benefits would be earned income that you'd have to report on your tax return.
Social Security disability benefits aren't earned income, and neither are military disability benefits. They are unearned income. In addition, most people receiving Social Security and military disability won't have to pay taxes on their benefits unless they have a lot income from other sources. In that case, some of your disability benefits may get eaten up by taxes. Then again, if you have a lot of income from other sources, you may not need or even qualify for government disability payments.
The distinction between earned and unearned income affects whether you qualify for tax breaks. Some tax credits are available only to people with earned income. For example, if you pay someone to take care of a child or other dependent, you may be eligible for a tax credit, but only if the money you pay comes out of earned income. When disability payments are considered earned income and treated like wages, they may help you qualify for such tax breaks.
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