You may be concerned about your tax burden if you are dealing with a serious condition that affects your working ability. Many people in these situations retire and receive a disability pension from their employer. Unfortunately, the general rule is that a disability pension is subject to tax, although there are some exceptions and limitations. People who receive a disability pension through their employer must report that pension as income on Form 1040 if they retire early with a disability. They will pay income tax on the pension, and they also will pay Social Security and Medicare taxes on it, since it is considered wages. When they reach their minimum retirement age, the disability pension will be classified as a pension or annuity. This means that an individual will need to pay income tax but no further Social Security or Medicare taxes. Their minimum retirement age is the age at which they would be able to start receiving a pension or annuity if they were not disabled. The documents for their plan should contain the minimum retirement age, or they can consult their employer if they are unsure.
A lump sum payment for accrued annual leave at the time that you retire based on a disability will be included as part of your income in the year that you receive it. This does not count as part of your disability payments.
Disability Payments Excluded from Taxes
If you receive workers’ compensation benefits following an accident or illness on the job, you likely will not need to pay tax on these payments. Similarly, if you were involved in a car accident, any disability benefits that you recover for your loss of income or earning capacity through a no-fault insurance policy will not be subject to tax. If you file a lawsuit and recover compensatory damages for an injury or illness, these damages will not be taxed. (It is important to be aware that any punitive damages will be taxed.) Any compensation awarded for the permanent loss of use of a body part or the loss of a function of your body will not be subject to tax, nor will any compensation related to permanent scarring or disfigurement.
If you receive benefits from a public welfare fund due to a disability, these will not be taxed. Former members of the U.S. armed forces will not be taxed on VA disability benefits. These may cover a wide range of costs related to a disability and the equipment or care needed to treat the disability.
Tax Credit for People with Disabilities
You may be able to receive a tax credit based on a permanent and total disability at the time of your retirement if you meet certain eligibility criteria. You must be over 65 or must be receiving taxable disability income. Strict income limits apply to this tax credit. If you are married, the combined adjusted gross income of your spouse and you cannot exceed a certain amount.