It’s critical to understand how disability benefits are taxed if you have or expect to receive one. The majority of disability pensions, but not all, are taxable.

Employer Disability Pensions

If you retired early due to disability, you must include any disability pension you receive under an employer-paid plan in your income. Until you reach the minimum retirement age, you must report your taxable disability payments as wages on Form 1040. If you are not disabled, the minimum retirement age is the age at which you can begin receiving a pension or annuity. Check the plan documents or ask your employer if you don’t know what your plan’s minimum retirement age is. Because this pension income is considered employee wages, you must pay income tax on it, as well as Social Security and Medicare taxes.

Payments received after reaching the minimum retirement age are taxable as a pension or annuity and must be reported on your tax return as such. The payments are subject to income tax, but not to Social Security or Medicare tax. See IRS Publication 575, Pension and Annuity Income, for more information on pensions and annuities.

Accrued Leave Payments

If you retire on disability, any lump-sum payment for unused annual leave is considered a wage payment. This is not a disability payment. Include it in your income for the tax year in which you receive it.

Military and Government Disability Pensions

Certain military and government disability pensions are exempt from income tax.

VA Disability Benefits.

You do not have to pay income tax on disability compensation from the Department of Veterans Affairs (VA). On your tax return, do not include such amounts in your income. Among the VA benefits are:

• Allowances for education, training, and subsistence
• Veterans and their families receive disability compensation and pension payments for disabilities.
• Grants for wheelchair-accessible housing
• Vehicle grants for soldiers who have lost their sight or use of their limbs
• Insurance revenues and dividends paid to veterans or their beneficiaries, include proceeds from a veteran’s endowment policy paid before death
• Interest on insurance profits held in trust by the VA
• Advantages of a dependent-care support program
• The death gratuity paid to the survivor of an Armed Forces member who died after September 10, 2001, or
• Money received under the VA’s compensated work treatment program

Other Nontaxable Disability Payments

Other non-taxable disability-related benefits 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
• disability 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

If you were totally and permanently disabled when you retired and are getting taxable disability income or are over 65, you may be eligible for a tax credit between $3,750 and $7,500. To get the credit, however, you must have a very low income. For example, a married couple can’t have more than $25,000 in adjusted gross income. You can use an online tool from the IRS to find out if you qualify.