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Disability Benefit Payments – How Are They Taxed?

Posted by Tax Advisor on 15 June, 2012

Everything you need to know about the different components of your disability benefit payments and how each is taxed

The taxes surrounding disability benefit payments can seem complicated, but once you break it down and look at the rules as they apply to each component it makes a lot more sense.

A disability benefit is a government payment you can receive if you suffer from a physical or mental illness that two doctors certify makes you incapable of gainful employment in a position for which you would otherwise be qualified.

The Department of Human Services handles disability benefits payments, so they cannot be claimed through the ATO. But come tax time, the ATO may require that you report and pay tax on a portion of your disability benefit payments. The question is, how much on which part?

Break it down

Your disability benefit payments will be divided into a tax-free component and a taxable component.

You don’t have to worry about the tax-free component – it’s not assessable and you don’t have to include it on your return.

But you do have to worry about the taxable component which may itself be divided into a taxed element and an untaxed element.

The taxed element has already had some tax paid on it, but depending on your age and you may need to pay more and include this amount on your return as assessable income.

The untaxed element hasn’t had any tax paid on it and you will definitely need to include this amount on your tax return as assessable income.

There are two different ways you can receive your disability benefit payments: either as a lump sum or as an income stream. How the different parts of your benefits are taxed depends in part on how you receive your payments.

If you receive your disability benefit as a lump sum

As stated above, you don’t have to pay anything on the tax-free component of your disability payment, which means that we are only concerned with the taxed element and untaxed element of the taxable component.

Here’s what happens to the taxed element depending on your age:

  • 60 and over – You do not owe tax on it
  • At or above preservation age and below 60 – You don’t owe any tax up to the low-rate cap amount of $165,000 for 2011-2012 or $175,000 for 2012-2013. Over the cap it’s taxed up to 15%.
  • Under preservation age – You will be taxed up to 20%.

Here’s what happens to the untaxed element by age

  • 60 and over – You will be taxed at 15% up to the untaxed plan cap of $1.205 million for 2011-2012 and $1.255 million for 2012-2013. Beyond that it is taxed at your top marginal rate.
  • At or above preservation age and below 60 – You will be taxed at 15% up to the low-rate cap amount of $165,000 for 2011-2012 and $175,000 for 2012-2013. Above this cap, you will be taxed at 30% until the untaxed plan cap amount of $1.205 million for 2011-2012 and $1.255 million for 2012-2013. Above this cap benefits are taxed at the top marginal rate.
  • Under preservation age – You will be taxed at 30% up to the untaxed plan cap amount of $1.205 million for 2011-2012 and $1.255 million for 2012-2013. Beyond this they are taxed at the top marginal rate.

If you receive your disability benefit as an income stream

Just as with a lump sum, you don’t have to pay anything on the tax-free component of your disability payment, which means that we are only concerned with the taxed element and untaxed element of the taxable component.

Here’s what happens to the taxed element, depending on your age.

  • 60 and over – No tax payable
  • Under 60 – You will be taxed at your marginal rate and you will get a tax offset amounting to 15% of your income stream’s taxable component.

Here’s what happens to the untaxed element, depending on your age:

  • 60 and over – You will be taxed at your marginal tax rate and you will receive a tax offset amounting to 10% of the untaxed element.
  • Under 60 – You will be taxed at your marginal rate. There is no tax offset for the untaxed element.

How will I know what to include on my tax return?

If all of your disability payment is tax-free, then you don’t have to worry about including any of it on your tax return.

If your disability payments include a taxable component, you should receive a payment summary that outlines the tax-free and taxable components of your benefit as well as whatever tax offsets you can claim. You must report all of the taxable component.

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