In the tax world, you usually can’t have your cake and eat it too.
Example: If physician practice employers provide disability insurance coverage to employees (including physician employees) on a pretax basis, any actual disability benefits paid out are taxable to the employee. On the other hand, if employees pay for coverage with after-tax dollars, any future benefits they receive would be tax-free.
Strategy: Physician practices can give their employees a choice. The practice can set up a disability insurance plan so that employees can choose their tax poison. Either they are taxed up front on the coverage or they can choose to elect to avoid tax until the benefits are paid out.
Are employers allowed to give employees the choice? The IRS recently approved this type of setup. (IRS Revenue Ruling 2004-55) The ruling says that it’s OK for employees to switch their positions in a subsequent year. Employees might choose to pay tax up front as they near the end of their working careers, especially if their health is beginning to fail. That way, any actual disability payments will be tax-free. Conversely, younger employees might generally opt for tax-free coverage, figuring it’s unlikely they will receive any disability payments.