Taking time off work is always a bit of a stressful situation. If you’re fortunate enough to have paid leave, this can help minimize the impact that it has on your finances. But, even if you do receive a paid leave, there can be unforeseen issues that crop up that you didn’t think about.
One of the main problems is that each type of leave and how it’s handled by your employer will differ. In some cases you may notice little change and your paychecks keep arriving as usual. In other cases you may actually have to go through the process of filing a claim with an insurance provider to collect your benefits. Understanding how this will affect your financial situation can prevent bigger problems from popping up down the road.
A Recent Personal Example
As you may recall, we recently had a baby so we had a chance to experience the impact that taking leave from work, even if paid, can have on our finances. Here’s how our scenario played out.
Both my wife and I were both fortunate enough to have some paid time off for the birth of a child that fell under FMLA, or the Family Medical Leave act of 1993. I was granted two weeks of paid time off, and my wife was granted eight weeks paid. We both had the option to get up to 12 total weeks if the remaining time was unpaid. While paid leave is a nice benefit, it was actually interesting to see how differently they were handled.
My leave was 100% pay and didn’t require me to file for disability benefits or anything like that. On the other hand, my wife’s paid leave was only 60% (which is pretty standard for short-term disability) and we had to file directly with the insurance company her employer uses for disability claims.
So, right there you can see how a reduction in pay alone can throw your finances out of whack. But, that isn’t the real problem. Most of the problems didn’t present themselves until some time later.
Paid Leave by Payroll vs. Insurance
Here’s where the real issues can start to crop up. If your leave is paid out by your empmloyer through payroll, there’s a good chance that nothing will really change. This was true in my case as mentioned above. My paychecks were deposited as usual, 401k deductions taken out, taxes withheld, so it was just like any other pay day. But when dealing with a disability insurance claim, you’re probably going to experience something completely different.
The first thing that will probably stand out is how your disability payments are taxed. Disability payments may or may not be taxable and it depends on how your plan is paid for. Here are a few examples:
- A person buys individual disability insurance from an insurance company. He/she pays the premiums with after-tax dollars, that is, the premiums are not deducted from taxable income as a business expense or otherwise. Because the premiums were included in taxable income, any benefits that person receives from the policy due to disability are not income taxable.
- An employer provides short term and long term disability to all eligible employees, and provides them as an employee benefit without cost to the employees. Because the employer deducts such payments from its income as a business expense, any disability benefits received by disabled employees are fully income taxable.
- An employer provides, without cost to the employees, a long term disability plan that pays 50% of their salary if disabled. Each employee has the right to additionally purchase, through payroll deduction, an additional 10% benefit to bring the total disability benefit up to 60% of income. The disability benefits are taxable in proportion to how the premiums were paid. Since the employer deducted the premiums for its coverage, any benefits received from that portion of the plan would be taxable, however, the benefit that comes from the portion the employee purchased with their after tax dollars would be income tax free.
As you can see, this can have a pretty significant impact on your disability income depending on how you receive the benefits. In our situation, short-term disability was paid for by my wife’s employer. The good news is that means we don’t pay a weekly or monthly premium for this benefit. But, that also means that her benefit is 100% taxable.
Not a big deal since income is taxable anyway, but here’s one of the issues — the insurance company does not withhold taxes for you. Now, if you’re planning ahead for this, that can actually be a good thing. You put more money in your pocket and can put it to work in a way that’s better than the IRS hanging onto it. But, most people don’t even realize that taxes aren’t withheld or forget about it, and guess what happens come tax time? That’s right, they are shocked because they might suddenly owe more taxes than expected in April. So, if you’re receiving disability benefits, make sure you understand how it should be taxed, if at all, and then plan accordingly to avoid surprises.
Retirement Plan Contributions
Here’s another one that can sneak up on you if you’re receiving a benefit from an insurance company instead of getting paid through payroll. In most cases, your 401k contributions will not be deducted. This means if you’re currently contributing to your retirement plan and begin receiving disability while you’re off, you could go weeks or even months without making any retirement plan contributions.
This came as a bit of a blow to us because we don’t qualify for deductible traditional IRAs, so our 401k plans through work and an IRA for self employment income is the only option for pre-tax contributions. So, you have to make sure that if you still want to make retirement plan contributions that you make up the difference either by increasing your contributions for the rest of the year, deposit it into another account if you can, or have your spouse change their contributions. Otherwise, you may find that you end up going without making new contributions for a while.
Finally, another major issue to consider if you’re receiving your paid leave through insurance is that in most cases your insurance premiums will not be automatically deducted. If you’re having your health insurance premiums automatically deducted and then begin receiving disability, chances are you’re going to now need to write a check on your own to cover those premiums until you begin having regular paychecks again.
It is just one of those things you don’t really think about because it may have been automatically taken care of for so long, but it can be a nasty surprise when a few weeks into your leave you get a letter in the mail saying you owe the insurance company money to keep your policy in effect.
Plan for the Changes
Don’t wait until the last minute to see how taking a paid leave of absence from work will affect your financial situation. In some cases, you may seamlessly transition into your paid leave, but in others, you might find that you’re hit with less pay, no taxes withheld, no retirement contributions made, and the need to write a check out-of-pocket to keep your insurance going.
While these aren’t difficult things to plan for, if you’re under stress from having a child or physically disabled due to an accident or illness, these lttle things can easily be forgotten and add up to bigger problems down the road.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
Very interesting article. I've never thought about these things in great depth because I have never needed them. I'm sure many people are in a similar situation.
My wife and I are expecting in July, and while she will become a SAHM, I will need to take some time off. So I'll be sure to reference this article again when making my decision on how much time I want to take off and how I go about doing it. :)
Interesting article. I've never had reason to really look into anything beyond my PTO. I have short-term and long-term disability, just in case, but I have not considered how it would impact my finances beyond the 30 days to file. But, as far as time off goes, I usually take paid time for vacations, though I was looking into the possibility of taking a week unpaid next summer when I go overseas to study abroad, but I just discovered my company won't allow that. So, now I have to stockpile my PTO because I don't want to quit and then hope I can come back over a week. That's just silly in my opinion, and a waste of money for the company as they'd have to send me back through training. I still may fight that if I come up short. We'll see.
I am pretty sure you should re-check your tax rules as they apply to situations where employees and employers share premiums on a DI program. My understanding is that the employees receiving taxable benefits can deduct from those benefits the premiums they have paid and once they have deducted 100% of what they have paid, benefits become fully taxable - i.e. they are NOT taxed proportionate to what the employee paid
Depending on the state that you are in, your short term disability may be exempt from state taxes (CA, NJ, NY, HI) so check your state taxes as well.
It is very, very rare for a disability company to not withhold taxes. Normally they provide you with a W-4 so that you can select the deductions for this time period.
LTD plans sometimes have the option of "tax me now" or "tax me later" and based on the selection, LTD benefits may be tax free if you have paid imputed value of the benefit during the year.
As for insurance premiums, before you go out on leave, you can pre-pay your premiums - generally through payroll - so that you still get the benefit of the pre-tax deduction. Or depending on the company, there can be a catch-up contribution once you return to work. So with a little bit of planning, you can still get the advantages of having pre-tax benefit deductions.
I never realized that paid leave would affect your personal finances. It's nice to have this pointed out. Although I don't think a lot of people see this as a major issue.
If, while my wife was out on leave, she had to pay her medical insurance premiums via check (i.e. not through payroll deductions), and therefore, these out-of-pocket medical premiums paid were not reflected on her W-2 as a reduction to her taxable income, we were debating whether we could "manually adjust" her taxable income for these premiums paid since they were paid to an eligible tax-free cafateria plan? It makes sense to me that the tax treatment should be the same (i.e. tax free) regardless of whether they were paid via payroll or via a written check?