At the outset, they can seem complicated. The impact of taxes on certain employee benefits, though, really boils down to one thing – who’s paying the premium. Take disability income insurance. People who are too sick or hurt to work are paid a benefit. It won’t replace their entire gross salary, but like medical insurance, it’s a benefit.
Is it taxable? Possibly. The same goes for supplemental coverage, like accident or critical illness insurance. Depending on who pays the premium, the benefit may or may not be taxed. It shapes up like this:
If the employer pays premium, the benefit is taxed. If the employee pays premium, the benefit generally isn’t taxed since premiums are paid post-tax dollars. If the premiums run through a section 125 plan, the benefit is taxed because premiums have been paid with pre-tax dollars.
You likely knew that. But, let’s consider the profound effect these taxes can have on the insured, especially in cases where their full income isn’t being replaced. Pile that on top of medical bills, and the financial impact grows.
Here are some examples to help employers better understand the human impact based upon who’s paying the premium.
On disability, for instance, a person making $50,000 a year assuming a 25% tax bracket with a 60% benefit would receive a monthly benefit of $1,875 if the employer pays the premium. On the flip side, if the employee pays the premium, the benefit would be $2,500. That takes the replacement ratio of take-home pay from 60% to 80%.
A person receiving a $50,000 critical illness benefit would receive only $37,500, assuming a 25% tax bracket if premiums were paid by the employer.
That’s $12,500 less available to them to help pay their extra medical expenses.
Clearly, it makes a difference.
These alternatives are ones you can suggest to your clients if they want to offer their employees benefits that aren’t taxable at claim time:
Offer the benefit as employee-paid (voluntary). Premiums are paid with post-tax dollars, so the benefit isn’t taxable. Sure, it reduces the employer’s tax deductions, but it’s still an overall reduction in total expense for the employer and gives the employee a higher replacement ratio.
Consider a bonus up, or gross-up, tax structure, where the employer pays premiums and the premiums are reported as taxable income for the employee. This turns employer dollars into employee dollars, and the benefits are paid post-tax. While there will be taxation on the premium, it’s typically minimal compared to the taxation on the benefit.
Another way you can bring clients more value is to work with carriers who can provide administration of tax reporting.
These carriers can do most of the heavy lifting for employers by providing W-2 and FICA services. They can help simplify the tax administration if a claim happens and help employers comply with government requirements.
Taxation is one piece of the employee benefits puzzle. Help employers solve that puzzle with solutions that address the tax implications to employees.