Tax implications of employee benefits

Man who has considered the tax implications of employee benefits.

Taxes are a fact of life for business owners, and at the outset, can seem complicated. That’s why it’s important to get simple answers. Have you considered how taxes impact the group benefits—like life insurance and disability insurance—you offer employees, and how you structure those benefits?

Are employee benefits taxable?

The tax implications of employee benefits depend on:

  • Who’s paying the premium—the business or the employees
  • If the premium is paid pre- or post-tax
  • What the benefit is (e.g. life insurance, disability insurance, etc.)

There are several approaches to structuring benefits to address their tax implications.

Taxes on group life insurance

Did you know the first $50,000 of an employer-provided group life benefit can be excluded from employee compensation, according to the Internal Revenue Service? That’s right. And it’s why some businesses pay premiums on the first $50,000 of group term life insurance, while offering coverage above and beyond that at their employees’ expense.

Keep in mind, if you do pay life insurance premiums above $50,000 per employee, you’re obligated to treat it as taxable income for tax reporting and withholding purposes (e.g., income, Social Security and Medicare taxes).

Check out the life insurance IRS tax rules (PDF) for more information.

Taxes on group disability benefits

If you offer employer-paid group disability insurance—meaning your business pays 100% of the premium—the benefit is 100% taxable to employees. However, premiums aren’t reported as taxable income to employees.

But consider an approach for disability coverage where your business shares the premium cost with employees (i.e., premiums partially paid by employer and employee). The benefit would be partially taxed, with the portion of the benefit attributable to the employer’s premium contribution being taxable.

Paying disability insurance premiums on a post-tax basis can increase the benefit an employee receives while they’re out of work on a disability claim.

How paying disability premium post-tax can impact employee benefits

Monthly benefit for an employee earning $60,000/year

60% benefit, pre-tax premium60% benefit, post-tax premium
Gross monthly income$5,000$5,000
Take-home pay (22% tax bracket)$3,900$3,900
Gross monthly benefit$3,000$3,000
Tax on benefit1 (22% tax bracket)$660$0
Payable monthly benefit$2,340$3,000
Replacement ratio260%77%

Monthly benefit for an employee earning $165,000/year

60% benefit, pre-tax premium 60% benefit, post-tax premium
Gross monthly income$13,750$13,750
Take-home pay (32% tax bracket)$9,350$9,350
Gross monthly benefit$8,250$8,250
Tax on benefit1 (32% tax bracket)$2,640$0
Payable monthly benefit$5,610$8,250
Replacement ratio260%88%

Simplifying taxes for disability claims

Since group disability benefits can be structured differently, understanding the tax implications for your business can be a challenge.

Have group disability through Principal? Learn more about our W-2 preparation and FICA match service (PDF),

Taxes on employee-paid benefits

Offering employee-paid benefits—also known as voluntary benefits—is a way to provide employees with benefits at group rates. Depending on how the benefits are structured, they may be received tax-free or be taxable.

If employees pay premiums with post-tax dollars, benefits are received tax-free.

If employees pay premiums with pre-tax dollars via a Section 125 premium-only plan, some benefits may be taxable. With a Section 125 plan, employees pay for employer-sponsored benefits on a pre-tax basis, increasing their take-home pay while decreasing employer payroll taxes.

How a Section 125 plan can impact an employee’s take-home pay

Take home pay of an employee earning $60,000/year with $100/month premiums

 Pre-tax premiums (Section 125 plan)Post-tax premiums
Gross monthly income $5,000$5,000
Pre-tax premium- $100- $0
Taxable income= $4,900= $5,000
Taxes1 (22% tax bracket)- $1,078- $1,100
Post-tax premium- $0

- $100

Take-home pay= $3,822= $3,800

Premiums for most group insurance benefits can be paid pre-tax through a Section 125 premium-only plan.

  • For dental and vision insurance, benefits are received tax-free even when premiums are paid pre-tax.
  • For term life insurance, only the premium for the first $50,000 of benefits on the participant’s life can be paid pre-tax.
  • For disability, critical illness, and accident insurance, benefits are taxable when premiums are paid pre-tax. When you’re considering including these coverages in a Section 125 plan, weigh the slight increase in employee take-home pay against reduced benefits.

Learn more about group benefits insurance from Principal

Does not consider account for employment taxes such as Social Security and Medicare.

The replacement ratio is calculated by dividing the payable monthly benefit by take-home pay.

This content is intended to provide accurate and authoritative information on the subject matter covered. The accuracy of this information is not guaranteed and is provided with the understanding that Principal is not rendering legal, accounting or tax advice. While this communication may be used to promote or market an idea that is discussed in this publication, it is not a marketed opinion and may not be used to avoid penalties under the Internal Revenue Code. Consult with legal counsel or other professional advisors on all matters pertaining to legal, tax or accounting obligations and requirements.

This summary is not a complete statement of the rights, benefits, limitations and exclusions of the coverage described here. For cost and coverage details, contact your Principal® representative.

Insurance from Principal issued by Principal Life Insurance Company, Des Moines, IA 50392.

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