Although an employer-paid plan using pre-tax dollars can save your physicians thousands in the short run, the taxation of disability benefits in the long run can cost hundreds of thousands of dollars. Here’s what you need to know about IRS Ruling 2004-55 and the 162 Bonus Plan.
When is $10,000 a month in group LTD benefits not really $10,000 a month in protection? Many physicians have discovered the value of adding Group Long Term Disability (LTD) coverage as a supplement to their individual disability (IDI) policies. By adding an additional $10,000 to $15,000 a month in Group LTD benefits, these physicians are able to bridge some or all of the “protection gap” they have between their current income and their IDI coverage.
If the physicians in your practice are covered under your Group LTD policy, they can save money now by paying their premiums with pre-tax dollars. In this scenario, your group practice pays the cost of their coverage and deducts the premiums as a business expense (similar to the tax treatment for other employee benefits).
On the other hand, if your physicians pay for their Group LTD coverage with post-tax dollars and then become disabled, how much more would they receive in disability benefits?
To answer this question, consider the following examples of a physician who pays premiums for $10,000 of monthly disability coverage for 10 years and is then disabled for the next 10 years. These examples demonstrate how a $10,000 tax savings (pre-tax approach) could cost almost $400,000 of benefits (post-tax approach) in the long run.
EXAMPLE 1: GROUP LTD PREMIUMS PAID WITH PRE-TAX DOLLARS
10 years of monthly LTD premiums
120 months x $250 premium = $30,000
Tax savings (33 1/3% tax rate) = $10,000
Income needed to pay $30,000 = $30,000
LTD benefits if pre-tax dollars
10,000/month x 33 1/3% tax rate = $6,700 after-tax benefit
120 months x $6,700 = $804,000
EXAMPLE 2: GROUP LTD PREMIUMS PAID WITH POST-TAX DOLLARS
10 years of monthly LTD premiums
120 months x $250 premium = $30,000
Tax expense (33 1/3% tax rate) to net $30,000 = $14,776
Income needed to pay $30,000 = $44,776
LTD benefits if post-tax dollars
120 months x $10,000 = $1,200,000
If $804,000 is enough for your physicians to maintain their current lifestyles over 10 years, that’s great news—they have planned well. If, however, they could use another $396,000 in additional income if they become disabled, you should consider allowing your physicians to pay premiums with post-tax dollars. Before you do this, take into account the IRS’ ”Three Year Look-Back Rule.”
Assumptions: Pre-disability income of $300,000; LTD Benefit equals 60% of Monthly Earnings; and 33 1/3% Federal Income Tax rate.
Three Year Look-Back Rule
This rule states that when your physicians change how they pay group disability premiums—from paying premiums with pre-tax dollars to paying with post-tax dollars—the IRS does not immediately allow them to receive non-taxable disability benefits. The IRS is concerned that an employer will change how premiums are paid right before a claim occurs, and try to avoid paying taxes on benefits that have been provided without cost to the employee by the employer.
After a change in how disability premiums are paid, and if a disability occurs within the next three years, the IRS will look back three years to determine how premiums were paid. The ratio of pre- and post-tax payments will then be applied to determine what percentage of disability benefits is taxable. For example: If a physician changes from an employer-paid to an employee-paid premium basis, and exactly two years later has a claim and begins receiving benefits, the IRS will determine that one third of the premiums were employer-paid and therefore taxable as income, while two thirds of the premiums are non-taxable.
Revenue Ruling 2004-55
With Revenue Ruling 2004-55, the IRS issued guidance that offers an alternative to the three-year, look-back rule. This ruling set forth IRS guidelines regarding tax treatment of short and long term disability benefits under sections 104(a)(3) and 105(a) of the Internal Revenue Code.
Under 2004-55, an employer is permitted to amend its disability plan so that employees who make an irrevocable election before the start of a plan year to pay disability premiums with post-tax dollars avoid the taxation that may be imposed under the “Three Year Look-Back Rule.”
162 Bonus Plan
Commonly referred to as an Executive Bonus Plan, a 162 Bonus Plan is one of the easiest ways to fund post-tax payments for disability coverage. Under Internal Revenue Code Section 162, your corporation can create an annual bonus to fund your Group LTD premium. Although this bonus is treated as income to your physicians, it is generally tax deductible to your corporation.
Additionally, because a physician’s personal income tax bracket is generally lower than your corporation’s bracket, this is often a good way to reduce overall or double taxation (taxation upon your corporation’s profits and again on your physicians’ personal income when earnings are distributed).
Income Protection Maximized
If your physicians are looking to maximize their income protection in the event of a disability, they should carefully consider how they pay Group Long Term Disability premiums. Now, with IRS Ruling 2004-55 and using a 162 Bonus Plan, your group can truly achieve the best of both worlds—competitively priced Group LTD coverage and non-taxable benefits at time of claim.
Note: This article is not intended to provide legal or tax advice. Before changing how you pay your premiums or implementing a 162 Bonus Plan, you should consult your tax and/or legal advisor.
Group disability insurance policies are underwritten by Sun Life Assurance Company of Canada (Wellesley Hills, MA) in all states, except New York, under Policy Form Series 93P-LH, 07P-LH-PT/07C-LH-PT, 12-STDPort-C-01, 12-GP-01, and 12-DI-C-01. In New York, group life and disability insurance policies are underwritten by Sun Life and Health Insurance Company (U.S.) (Windsor, CT) under Policy Form Series 13-GP-LH-01, 13-LTD-C-01-MGIS, 13-STD-C-01-MGIS, 13-ADD-C-01-MGIS, 13-GP-LF-01, 13-LF-C-01-MGIS, 12-GPPort-01, 13-LFPort-C-01, 13-ADDPort-C-01 and 12-STDPort-C-01. Administration for physician products is provided by Medical Group Insurance Services, Inc. (MGIS), in all states, except as follows: in CA by MGIS Insurance Agency, Inc.; in NY by MGIS Insurance Agency. Product offerings may not be available in all states and may vary depending on state laws and regulations.
The disability policies provide disability income insurance only. They do NOT provide basic hospital, basic medical, or major medical insurance as defined by the New York State Insurance Department.