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Posted by Louise Gagne, FICA, FSA, avril 24 2019
Disability Cases
Long-Term Disability Insurance: Taxable or non-Taxable?

long-term-disability-insurance

In a group insurance plan, long-term disability insurance (wage loss replacement) is often the most important benefit for your employees. In case of serious illness or injury, this coverage will provide them with income continuation should they be off work for an extended period.

However, choosing the right formula is key to adequate coverage, as long-term disability benefits can be taxable or non-taxable. To select the right coverage for your employees, here are some factors to consider!

Condition for making disability benefits non-taxable

For disability benefits to qualify as non-taxable, the condition to be met is that the cost of premiums must be 100% paid by employees, and 100% also means by all employees within the category covered under the benefit, without exception. Failure to comply with this condition could lead to what is known in the insurance world as “contamination” of the long-term disability insurance, making all benefits (even those that were paid in the past) taxable.

Food for thought regarding long-term disability insurance

A fairly widespread assumption is that non-taxable disability benefits are more profitable for employees and less costly for employers. This is not necessarily the case. Below are a few commonly held beliefs along with our take on them:

Employees end up with more money in their pockets with a non-taxable disability benefit

  • Well-designed long-term disability coverage should provide net replacement of 80%-85% of the pre-disability income. This level can be reached whether the benefit is taxable or not; it’s all about choosing the right formula.

Tiered formulas used for non-taxable disability benefits are all alike and can apply to any group

  • When selecting the disability benefit calculation formula, it is crucial to consider the salaries of the employees to be covered. A formula where the 85% income replacement objective is reached for employees with an average salary of $40,000 will not bring about the same outcome for high-income earners. Some employees could even end up paying for benefits to which they will never be entitled.
  • In most contracts, a maximum of 85% of the salary (net or gross, depending on the tax treatment of the benefit) applies to the calculated disability benefit. This ceiling could prevent a disabled employee from receiving the full benefit for which he/she paid premiums.

Non-taxable coverage is less costly for employees and employers alike

  • It is true that when we consider only the cost of the long-term disability coverage, the total cost will be lower for non-taxable coverage than for taxable coverage (even for an equivalent net income, as the volume on which the premium is calculated will be lower).
  • However, for employers who want to pay the same percentage of the total cost of the insurance plan for their employees, the answer will not be the same when taxable employment benefits and payroll taxes are included in the equation. It is even possible that savings could be achieved with taxable coverage, both for employees and employers.

What is the best option?

So, is it more profitable to go with taxable or non-taxable disability benefits? Generally, in Quebec, when employers want to maintain the same contribution to the total cost of their group insurance plan in either case, going with taxable disability coverage is more profitable for everyone. As employer-paid premiums for health and dental coverage are a taxable employment benefit in Quebec whereas employer-paid long-term disability premiums are not, it is indeed more tax-effective for an employee to have the employer pay for long-term disability insurance (which thus becomes taxable) rather than for health/dental coverage. However, the precise answer will depend on the replacement formulas used and the salaries of the employee groups covered.

In the other provinces, the health/dental premiums are not taxable, and the most profitable option is generally the opposite, i.e. non-taxable long-term disability insurance.

Choosing the right type of long-term disability benefits is not always easy. If you are wondering what would be the best option for you, contact your AGA Advisor who will analyze the overall picture of your group insurance plan and recommend the course of action most suited to your situation!

managing-disability

Louise started her career at Blue Cross before working as a Senior Advisor for a large actuarial firm for more than 15 years. Fellow of the Canadian Institute of Actuaries, Louise joined AGA in June 2014. She assumes responsibility for training, provides technical support, and supplies advisory activities for the large business clientele. Louise is also lecturer at l’UQAM.
Louise Gagne, FICA, FSA