Taxation of Disability Benefits in Canada

Navigating the complexities of disability benefits and their taxation can be overwhelming. Whether you’re receiving Short-Term Disability (STD), Long-Term Disability (LTD) benefits, or the Canada Pension Plan (CPP) Disability Benefit, understanding the tax implications if crucial for your financial planning and future.

At Valent Legal, we strive to provide clear, up-to-date information to help you understand how your disability benefits will be taxed in Canada. To learn more about your tax situation with the help of a legal professional, contact our disability benefits lawyers today. 

Understanding STD and LTD Benefit Taxation

Traditionally, Short Term Disability (STD) and Long Term Disability (LTD) benefits were not taxed at the time they were issued. Instead, STD and LTD benefits would be taxed when you filed your annual income tax returns. As of January 2015, however, the Canada Revenue Agency (CRA) updated its disability benefit tax regulations. Now STD and LTD benefits are taxed at the time the payments are issued.

Most often, all disability benefits received are subject to taxation. Employer-paid premiums, however, can become complicated depending on who is ultimately paying for them and whether they are paid for in pre-tax or post-tax dollars.

Employer-Paid Premiums

In Canada, usually no matter the type of income, you are taxed on all forms of compensation you receive from your employer. This includes salaries, wages, bonuses, and employer-provided parking. However, STD or LTD premiums do not count as taxable benefits when paid by employers. This means you receive an advantage of being covered by your employer’s STD or LTD insurance policy, but do not have to pay tax on the benefit of the coverage you receive.

STD or LTD premiums not counting as taxable benefits is advantageous, as long as you do not need to use the policy in the event of a disability. The trade-off is, you will have to pay tax on any benefit you get under an STD or LTD policy if you become disabled and unable to work.

Instead of an employee being taxed to the full extent on their STD or LTD benefits, most employers will have employees pay the STD and LTD premiums via payroll deductions or as a lump sum on their T4 at the end of each year. If an employee is covering 100% of their premium throughout their employment, they will receive all disability payments tax-free.

If an employer is paying 100% of all insurance premiums, your employer should ensure the STD or LTD schedule is higher to account for the taxation that will occur of the disability benefits paid out.

Determining whether your STD and LTD benefits are taxable or not depends on if you are paying the premium with pre-tax or post-tax dollars.

• Pre-tax dollars would mean you are paying your insurance premium without paying the federal tax rate at that time.
• Post-tax dollars would mean you are paying your insurance premium and also paying the federal tax rate at the same time.

The difference between who pays the premium and whether it’s paid in pre or post-tax dollars can create several situations you might currently be in. 

Key scenarios for employer and employee contributions include:

1. Employer Pays a Portion, Employee Pays the Balance with Post-Tax Dollars

• Benefits are taxable in proportion to the employer’s contribution. For example, if you cover 50% of the premium with post-tax dollars, only 50% of the benefits are taxable.

2. Employer Pays a Portion, Employee Pays the Balance with Pre-Tax Dollars

• All benefits received are 100% taxable to the employee.

3. Employee Pays Entire Premium with Post-Tax Dollars

• Benefits received are entirely non-taxable.

4. Employee Pays Entire Premium with Pre-Tax Dollars

• Benefits received are 100% taxable.

Is it wiser to buy disability coverage with pre-tax or post-tax dollars?

There are many considerations to be made when deciding to pay your premiums with pre-tax or post-tax dollars. These might include:

• Work Environment: If you work in a high-risk environment where debilitating injuries are more likely, paying premiums with post-tax dollars may be wiser. This choice ensures that any disability benefits received are tax-free, providing greater financial stability during recovery
• Financial Stability: Paying more upfront with post-tax dollars can result in substantial tax-free benefits, which may better maintain your standards of living if you become disabled. Tax-free benefit payments could be closer to your regular take-home pay, helping you maintain financial stability while adjusting to living with your disability or illness.

If you choose to pay for your premium with pre-tax dollars and you become disabled, 100% of your disability benefits will be subject to federal income tax. This may significantly reduce the net amount you receive.

Do I have to report disability income on my tax return?

Determining whether you need to report disability income on your tax return depends on three factors:

• What portion of the premium was paid by the employer
• What portion of the premium was paid by the employee
• Did the employee pay their premium with pre or post-tax dollars?

The variability between these factors can create a number of situations:

1. If your employer paid for 100% of the premium, then the employee must report 100% of the benefit they receive on their tax return.

2. If the employee paid for 100% of the premium with pre-tax dollars, then the employee must report 100% of the benefit they receive on their tax return.

3. If the employee paid for 100% of the premium with post-tax dollars, then the employee is not required to report the benefit they receive on their tax return.

4. If the employer pays a portion of the premium and the employee pays the remainder with pre-tax dollars, the employee must report 100% of the benefit they receive on their tax return.

5. If the employer pays a portion of the premium, and the employee pays the remainder with post-tax dollars, the employee must report only the portion they did not pay for, but the employer did.

When disability benefits are awarded retroactively (arrears), the insurer and your employer will arrange to have an amended T4 (T4A) prepared. In order to limit the tax burden, the arrears can be spread over the years when you were entitled to benefits by filing a T-1198 with CRA. Again, your insurer and employer handles this for you on any negotiated settlement.

In addition, as of 2023, the Disability Tax Credit (DTC) has seen adjustments to its maximum amounts to keep pace with inflation. The non-refundable tax credit amount has increased, enhancing the financial support available to eligible individuals. Additionally, recent CRA guidelines have provided clearer distinctions between taxable and non-taxable benefits, reducing confusion for beneficiaries. 

The CRA has also introduced new online tools and resources as of 2023 to assist individuals in better understanding their tax obligations regarding disability benefits. For example, detailed guides online are offered to simplify the process of determining taxable amounts and filing your return accurately if you receive disability benefits.

Is the Canada Pension Plan Disability Benefit Taxable?

Beyond private insurance, disabled Canadians can apply for the Canadian Pension Plan (CPP) Disability Benefit. The CPP Disability Benefit is taxable and must be reported on your tax return. This benefit helps make up for lost earnings if you meet the criteria as defined by Service Canada.

You may be eligible for this benefit if you are:

• Under 65 years old
• Have a severe and prolonged disability that makes you unable to work
• Have made enough contributions to CPP before becoming disabled

The CPP Disability Benefit may be taxable, but if it is your only source of income, you will likely pay less in federal and provincial taxes due to your basic personal tax credit. Applying for the disability tax credit can also help you pay fewer taxes by increasing your basic personal tax credit.

What Disability Benefits Are Not Taxable?

Under the Canadian Income Tax Act, certain disability benefits are exempt from taxation. Specifically: 

• Personal Injury Settlements: As outlined in Subdivision G, income from personal injury settlements, particularly those covering lost wages, is not considered regular income and is therefore non-taxable. In almost every personal injury settlement we see, a portion of the settlement is used to cover lost wages. It is reasonable to think that the CRA would consider this portion as regular income and tax them as such. However, the Canadian Income Tax Act is generous when it comes to personal injury victims. The recovery of lost wages is not considered regular income and is therefore not taxable.
• Compensation from Criminal Acts or Motor Vehicle Accidents: If you were a victim of a criminal act or a motor vehicle accident, the compensation you receive from provincial or territorial authorities is also exempt from taxation.

How Do I Claim the Disability Tax Credit (DTC)?

The Disability Tax Credit (DTC) is a non-refundable tax credit that helps individuals with disabilities as their supporting persons reduce the amount of income tax owed. As of 2023, the maximum disability amount has increased to $8,662 federally, reflecting annual adjustments for inflation.

To claim the DTC:

• Complete Form T2201 with the assistance of a medical practitioner
• Submit the form to the CRA for approval
• Ensure that the impairment is both severe and prolonged in order to qualify

Managing Tax Implications for Your Disability Benefits

To strategically manage your disability benefits and the taxes that you owe for the income you receive, there are a number of factors you may want to consider. These include:

• Integrating Tax Planning with Disability Insurance: Work with a financial advisor and legal professional to align your disability insurance choices with your overall tax strategy. This can help you decide between pre-tax and post-tax premium payments based on your financial situation and risk tolerance.
• Stay Informed About Legislative Changes: Tax laws and disability benefit regulations can change. Consult regularly with legal experts or subscribe to updates from the CRA to stay informed about any changes that may affect your benefits.
• Leverage Additional Tax Credits and Deductions: Beyond the DTC, you may want to explore other tax credits and deductions you might be eligible for, such as medical expense deductions, to further reduce your taxable income.

Contact Our Halifax Disability Lawyers at Valent Legal

The rules and regulations behind the taxation of STD/LTD benefits can be confusing for anyone. It is difficult to know if you need to report some, none, or just a portion of the disability benefits you receive on your tax report. 

If you are feeling unsure whether your disability benefits are taxable, please contact one of our experienced lawyers at Valent Legal. We can help you find the answers you’ve been searching for so you can feel confident submitting your annual tax report.