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.
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 Form 1040 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. Since this pension income is considered employee wages, you pay income tax on it and your and you employer both pay Social Security and Medicare tax as well.
Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension or annuity and must be listed as such on your tax return. You must pay income tax on the payments, but not Social Security or Medicare tax. 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 wage payment. The payment is not a disability payment. Include it in your wage 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:
Other Nontaxable Disability Payments
Other disability-related payments that are not taxable include:
Tax Credit for the Disabled
If you were permanently and totally disabled when you retired and are receiving taxable disability income or are over 65, you may be entitled to a tax credit ranging from $3,750 to $7,500. However, your income must be quite low to qualify—for example, a married couple can have no more than $25,000 in adjusted gross income to get the credit. The IRS has an online tool you can use to see if you qualify. For detailed information on this credit, see IRS Publication 524, Credit for the Elderly or the Disabled. Also,
For information on Social Security disability benefits, see Nolo's article on when SSDI is taxed.