In Is Social Security Disability Taxable I discussed when someone who receives disability benefits might owe taxes on those benefits. Whether your disability is taxable or not depends on what other income you have. To recap…
If you are single and your modified adjusted gross income plus half of your Social Security benefits is less than $25,000, then none of your Social Security benefits are taxable.
If your income is between $25,000 and $34,000, then up to half of your disability benefits will be subject to income taxes.
If your income is more than $34,000 then up to 85 percent of your Social Security may be taxed.
The limits are $32,000 and $44,000 respectively for taxpayers who are married and file a joint tax return with their spouse. If you are married and you file separately from your spouse then the income threshold is zero, which means you will pay taxes on your Social Security from the first dollar earned.
Based on these rules, many people who receive Social Security disability benefits will not owe taxes on their benefits simply because their income is too low.
However, many people report their benefits incorrectly, causing them to owe taxes unnecessarily.
If you have ever been on disability you know that it can take months or even years to receive benefits. Social Security has a very strict definition of disability and the process of qualifying someone for disability can be very lengthy.
As a result, many people receive a one-time lump sum payment that includes months or years of back-payments.
This lump sum payment can cause tax problems if it’s not reported correctly. According to IRS Publication 915 you must include the taxable part of a lump-sum payment received in 2011 in your 2011 income, even if the payment includes benefits for an earlier year. If you receive back-payments for multiple years then reporting all of the income in one year may cause your Social Security disability benefits to become taxable.
However, Publication 915 also states that you may be able to figure the taxable part of your benefits for an earlier year using that year’s income. By calculating your taxable income based on the year you should have received the benefits, you can avoid inflating your income and possibly paying taxes on your benefits that you would not have paid had you received them in the correct year(s).
Here is an example from IRS Publication 915:
Jane Jackson is single. In 2010 she applied for social security disability benefits but was told she was ineligible. She appealed the decision and won. In 2011, she received a lump-sum payment of $6,000, of which $2,000 was for 2010 and $4,000 was for 2011. Jane also received $5,000 in social security benefits in 2011, so her total benefits in 2011 were $11,000. Jane’s other income for 2010 and 2011 is as follows.
|
Income |
2010 |
2011 |
||
| Wages |
$20,000 |
$ 3,500 |
||
| Interest income |
2,000 |
2,500 |
||
| Dividend income |
1,000 |
1,500 |
||
| Fully taxable pension |
18,000 |
|||
| Total |
$23,000 |
$25,500 |
To determine if she should elect the lump-sum method to reduce the taxes owed on her Social Security benefits, Jane will need to complete Worksheets 1, 2 and 4 in Publication 519.
Without going into too much detail, if Jane reports all of the income in 2011, she will have to pay taxes on $3,000 of her Social Security benefits. If she chooses the lump-sum election, only $2,500 of her benefits will be subject to income tax.
To elect the lump-sum method of reporting her disability benefits, Jane just needs to enter “LSE” on line 20a of Form 1040 (line 14a if she is filing 1040A instead); she will also need to enter the amount calculated on Worksheet 4, the worksheet used to determine the taxable benefits under the lump-sum election method.
In Jane’s case she will save taxes because she will be reporting $500 less in taxable income. For people who have disability cases that go for several years, the tax savings by electing the lump-sum method could be much greater.
If you have received or expect to receive a lump-sum amount for disability benefits, it is strongly recommended that you contact a tax professional to help you determine the most beneficial tax reporting for you.
Resource: IRS Publication 915 – Social Security and Equivalent Railroad Retirement Benefits
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