If you have or expect to receive a disability pension, it's important to understand how disability benefits are taxed. Most, but not all, disability pensions are taxable.
Employer Disability Pensions
If you retired early on disability, you must include in income any disability pension you receive under a plan that is paid for by your employer. You report your taxable disability payments as wages on line 7 of Form 1040 or Form 1040A until you reach minimum retirement age. Minimum retirement age generally is the age at which you can first receive a pension or annuity if you are not disabled. If you don't know your plan's minimum retirement age, check the plan documents or ask your employer.
Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension or annuity. Report the payments on lines 16a and 16b of Form 1040 or on lines 12a and 12b of Form 1040A. For more information on pensions and annuities, see IRS Publication 575, Pension and Annuity Income.
Accrued Leave Payments
If you retire on disability, any lump-sum payment you receive for accrued annual leave is a salary payment. The payment is not a disability payment. Include it in your income in the tax year you receive it.
Military and Government Disability Pensions
You do not have to pay income tax on certain military and government disability pensions.
VA Disability Benefits. You need not pay income tax on disability benefits you receive from the Department of Veterans Affairs (VA). Don't include such payments in your gross income on your tax return. These VA benefits include:
- education, training, and subsistence allowances
- disability compensation and pension payments for disabilities paid either to veterans or their families
- grants for homes designed for wheelchair living
- grants for motor vehicles for veterans who lost their sight or the use of their limbs
- veterans' insurance proceeds and dividends paid either to veterans or their beneficiaries, including the proceeds of a veteran's endowment policy paid before death
- interest on insurance dividends left on deposit with the VA
- benefits under a dependent-care assistance program
- the death gratuity paid to a survivor of a member of the Armed Forces who died after September 10, 2001, or
- payments made under the VA's compensated work therapy program.
Other Nontaxable Disability Payments
Other disability-related payments that are not taxable include:
- benefit payments from a public welfare fund, such as payments due to blindness
- workers' compensation for an occupational sickness or injury if paid under a workers' compensation act or similar law (usually)
- compensatory (but not punitive) damages for physical injury or physical sickness
- dsability benefits under a “no-fault” car insurance policy for loss of income or earning capacity as a result of injuries
- compensation for permanent loss or loss of use of a part or function of your body, or for your permanent disfigurement.
Tax Credit for the Disabled
You may also be entitled to a tax credit if you were permanently and totally disabled when you retired. For information on this credit, see IRS Publication 524, Credit for the Elderly or the Disabled.
For information on Social Security disability benefits, see Nolo's article on when SSDI is taxed.