Individual income tax return form,


Victor Peña Law PLLC April 19, 2022

According to the U.S. Bureau of Labor Statistics (BLS), about one-third of U.S. employers offer their employees access to a long-term disability (LTD) policy. And, according to the Council for Disability Awareness (CDA), one in four of today’s 20-year-olds entering the workforce will experience a disability before retirement age, lasting an average of 34.6 months.

Without an LTD plan, personal savings, or family to provide support, those three years out of work could exact an extreme financial burden. That’s where LTD insurance policies can fill in the gap. Though they won’t cover all of your lost wages if you are forced to go out on disability, they will provide a good backstop.

Companies like Unum, The Hartford, MetLife, Cigna, and Lincoln Financial often underwrite these work-based LTD plans. Regardless of the insurance underwriter, employer-sponsored LTD plans are all covered by a law known as the Employee Retirement Income Security Act (ERISA). As such, they are subject to federal regulation that differs from privately-issued LTD plans.

If you do go out on disability and you’re receiving monthly disability payments, you or your insurer may at some point decide that it might be better just to settle everything with a lump-sum buyout. In other words, the insurer will give you a buyout check in lieu of continuing the monthly benefits. This, of course, will save them money in the long run, but it also may benefit you if your circumstances warrant it.

A question many people have is: Will the lump-sum settlement be taxable? The answer depends on who paid the premium (you, your employer, or both) and what percentage each.

Is a Buyout Worth It?

As previously mentioned, sometimes the LTD insurer will contact you proposing a lump-sum settlement. At other times, people out on LTD disability will weigh their options and determine that a buyout makes more sense than continuing monthly payments and being harassed by the insurer to provide regularly-updated medical information or undergo repeated medical exams.

A lot will depend, of course, on the policy, but also on the age and life expectancy of the insured party. If your LTD policy will pay until your death (which is unlikely), it might not make sense to take a lump sum, but most policies have shorter time frames and expire once you reach retirement age, if not before.

In this age of accelerating inflation, you as the insured should check to see whether your policy contains a cost-of-living-adjustment (COLA) clause. Some do, but they peg it at a low percentage increase per year, maybe two or three percent. If your policy is pegged to the consumer price index (CPI), then your benefits should keep up with inflation better.

Inflation is an important consideration in deciding whether to take a lump-sum settlement. If inflation is expected to continue at a high rate as it is now, you may be better off taking the lump sum and investing it. After all, the $3,000 a month you receive, for example, if it’s not pegged to the CPI, could be worth a lot less each year.

Another consideration in a buyout is that, should you die prematurely, your benefits will stop and your family will have no income. You could take a buyout and create an estate plan that would benefit your family should the unexpected happen. You also may want to take a buyout because you see a business opportunity that could take care of you and your family for the long term.

ERISA, the IRS, and Buyouts

As mentioned earlier, LTD policies offered at work are covered by ERISA, a federal law designed to protect employees but nonetheless contains various clauses that protect employers and insurance companies. For instance, ERISA establishes fairly stringent guidelines for appealing an adverse decision by an insurer and for filing a lawsuit against an insurer.

When it comes to buyouts, the Internal Revenue Service (IRS) also has a say in the matter. Remember from the opening section that taxes on an ERISA-based LTD buyout are based on who paid what percentage of the original premium. That is the standard the IRS employs.

The IRS states it all fairly succinctly: “If both you and your employer have paid the premiums for the plan, only the amount you receive for your disability that's due to your employer's payments is reported as income.” The rationale is that the employer paid with pre-tax dollars while the employee paid with post-tax dollars.

In other words, if your employer paid 50 percent of your premium while you were working and you paid the other 50 percent, when you receive a lump-sum buyout of, say $300,000, you would owe taxes on $150,000. The same would hold true for monthly benefits. If you receive $3,000 a month, $1,500 would be taxable.

Experienced Guidance You Can Trust

If your insurer has approached you about a buyout, or if you’re considering the option of seeking one, contact me immediately at Victor Peña Law PLLC so we can discuss the best direction you can take.

Located in Fort Lauderdale, Florida, my firm handles cases nationwide, including clients located in and around the areas of Los Angeles, Seattle, New York City, and Chicago.