California Life-Only & Accident and Health AgentAccident and Health InsuranceMedium
A life-only agent is explaining the taxation of disability income benefits to a client. The client has an individual disability income policy for which they pay all the premiums themselves. If the client becomes disabled and receives benefits from this policy, how will these benefits generally be taxed?
- AThey will be partially taxable, depending on the client's income.
- BThey will be tax-free.
- CThey will be fully taxable as ordinary income.
- DThey will be taxable at a capital gains rate.
Show answer & explanationAnswer & explanation
Correct answer: B. They will be tax-free.
When an individual pays the premiums for their individual disability income policy with after-tax dollars, the benefits received from that policy are generally tax-free. This is because the premiums were paid with money that had already been taxed.
Why the other options are wrong
- A. Partial taxation typically applies to Social Security Disability Income or some employer-sponsored plans, not individual policies where the insured pays all premiums.
- C. Benefits are fully taxable only if the premiums were paid with pre-tax dollars, such as through an employer-sponsored plan where the employer paid the premiums.
- D. Capital gains rates apply to profits from the sale of assets, not to disability income benefits.
Taxation of Individual Disability Benefits (Paid by Insured)
When an individual pays all premiums for their disability income policy with after-tax dollars, the benefits received from that policy are generally tax-free, as the premiums were paid with already taxed income.
- Premiums paid by insured with after-tax dollars.
- Benefits received are tax-exempt.
- Prevents double taxation.
Memory trick: Who PAYS the premium determines if BENEFITS are taxed.