Delicate balance Featured

8:29am EDT February 23, 2005
There is a very strong argument that employees should pay 100 percent of the premium for long-term disability (LTD) insurance. Although many HR executives and CFOs understand the value of this, many are not aware of the dangers associated with transitioning from employer-paid LTD to employee-paid LTD.

Generally, the taxability of group disability benefits is based on the portion of the total premium paid by the employer. If the employee pays 100 percent of the premium on a post-tax basis, the benefit is tax-free. This is true if you start your plan having the employees pay 100 percent of the cost. However, it is not the case if you change from 100 percent employer-paid to 100 percent employee-paid.

A recent IRS ruling provides a distinction in determining the taxability of disability benefits for certain plans. Under the three-year look-back rule, a covered employee would have to pay 100 percent of his or her LTD premiums for three policy years with post-tax dollars in order to receive nontaxable benefits.

If an employee becomes disabled in the first year of the employee-pay-all format, the benefits would still be 100 percent taxable. Year two would be 66 percent taxable, year three 33 percent taxable and not until three years had elapsed would the benefit be tax-free.

An employer needs to be very careful to communicate this important fact to employees during the transition. If you fail to communicate this correctly, you may find yourself making up the difference in a court of law. Remember that LTD claims can last until a person is 65 or 67 years old, making this a potential 40-year nightmare.

Despite this hurdle, it can still be a good idea to transition to employee-paid LTD.

See the above chart for the following examples.

In the first example (ER pay), the employer is paying 100 percent of the cost and the benefit is taxable. In the second example (EE pay), the employee pays 100 percent of the cost. Notice that the LTD rate increased by 20 percent.

The carriers will add as much as 30 percent to a rate based on the assumption that fewer than 100 percent of employees will participate and the fact that a claimant receiving a higher benefit is less likely to return to work. Although some employers will return income back to the employee to pay for the premium, LTD carriers will still load the rates, even if 100 percent of employees enroll.

Although the rate increased by 20 percent in this example, the cost of the premium is still relatively low. If an employee is on an LTD claim for just one month, the tax savings could be as much as 70 months of premium payments ($700 or $10 a month).

In reality, the employer-paid LTD benefit replaces only 43 percent of the pre-disability income. ($2,500 benefit minus $700 tax = $1,800 after-tax benefit; $1,800/ $4,167 = 43 percent)

The fact that the monthly premiums are relatively low helps the employee afford the LTD premium on his or her own.

There are several ways you can approach your employees with this transition from company-paid to employee-paid. Some employers say they are increasing their benefit from 43 percent to 60 percent for only $10 a month. Other employers explain that savings from the employer's LTD premium will be used to fund a new vision plan, which, in most cases, costs less than the LTD premium.

If you do not have a LTD benefit, you should seriously consider offering an employee-pay-all LTD plan. You insure your house, your car, your teeth and your health, but if you don't insure your paycheck, all the other items cannot survive. An LTD plan is the horse that pulls the rest of the benefit wagon.

Bruce Bishop ( is director of marketing and managing partner of KYBA Benefits. KYBA Benefits provides consulting and administrative services to more than 400 corporate accounts, ranging in size from 20 employees to more than 7,000. Reach him at (770) 425-6700 or (800) 874-2244, ext. 205.