Going on disability is a lot more common than you might think. The Social Security Administration says over 1 in 4 people in their 20s will become disabled before reaching age 67. Whether your disability payments count as earned or unearned income for tax purposes depends on when and from where you receive them.
Generally, short-term disability payments – as well as long-term disability payments received before retirement age – are earned income, while long-term disability payments received after retirement age are unearned income. There are some exceptions for insurance payments and government benefits, though.
While short-term disability payments are considered earned income, long-term payments that continue after retirement age are unearned.
Determining Wage Replacement
Some employers offer 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.
Insurance Payments Determination
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.
Certain Government Benefits
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 of 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.
Other Items to Consider
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.