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calculating disability insurance tax in Canada

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.

The employer pays a portion, and the employee pays the balance with post-tax dollars

If the employer pays a portion of the premium, and the employee pays the balance with post-tax dollars, then the benefits are taxable in the same proportion as the percentage of the premium paid by the employer. For example, if you paid for 50% of your premium with post-tax dollars, you would only be taxed on 50% of the benefit that your employer had been paying.

The employer pays a portion, and the employee pays the balance with pre-tax dollars

If the employer pays a portion of the premium, and the employee pays the balance with pre-tax dollars, then benefits received are 100% taxable to the employee.

Employee Paid Premiums with post-tax dollars

If an employee pays their entire premium with zero contribution from the employer with post-tax dollars, then any benefits they receive are non-taxable.

Employee Paid Premiums with pre-tax dollars

If an employee pays their entire premium with zero contribution from the employer with pre-tax dollars, then any benefits they receive 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. For example, what is the nature of your workplace? If you work in a hazardous environment where debilitating injuries are likely to happen, paying with post-tax dollars would be the wiser choice.

Accidents are always unpredictable and can be life-altering. If they do occur, you would be fortunate to receive your benefits tax-free for the duration of your short-term or long-term disability. To be prepared for the worst, it often can be beneficial to pay a little more now to receive a more substantial benefit if you experience an accident leaving you unable to work. 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.

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.

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 and 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?

The Canadian Income Tax Act specifies what you will and will not have to report as income on your annual tax return. In Subdivision G, we can see that the act states you do not have to report income from personal injury settlements and therefore is exempt from taxation.

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 Candian 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.

Another tax exemption given by the CRA is “compensation received from a province or territory if you were a victim of a criminal act or a motor vehicle accident.”

How do I claim the disability tax credit?

The DTC is a non-refundable tax credit that helps persons with disabilities or their supporting persons reduce the amount of income tax they may have to pay. It aims to provide greater tax equity for those living with a disability. If eligible for the DTC, you can receive upwards of an $8000 in federal credit. In 2019 the maximum disability amount a person could receive was $8,416.

To claim the Disability Tax Credit (DTC), you must have Form T2201 completed by a medical practitioner, and the CRA must approve it. You are eligible for the DTC only if you are considered to have a severe and prolonged impairment.

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. We can help you find the answers you’ve been searching for so you can feel confident submitting your annual tax report.

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