Under an employer-sponsored disability income policy, the employee pays the portion of the premium attributable to residual disability benefits and the employer pays the remainder. What are the tax implications of residual disability benefits?

• A. They are fully taxable as ordinary income
• B. Residual benefits will be received income tax-free
• C. They are tax-free only if premiums were paid with after-tax dollars
• D. They are subject to capital gains tax

Answer: (B)

Tax treatment of disability benefits depends on who pays the premiums and how. When premiums are funded with after-tax dollars, the benefits that come from those premiums are received tax-free. In this employer-sponsored plan, the employee is paying the portion of the premium tied to residual disability benefits with after-tax dollars, so the residual disability benefits are received income-tax-free. The portion funded by the employer would be taxable as ordinary income when paid. Capital gains tax does not apply to these disability benefits.