Lump-sum settlements often carry significant adverse tax consequences for the claimant. Often the tax bite makes taking a lump sum settlement less attractive than receiving monthly benefits.
This can best be explained by an example. Consider a 45-year-old claimant whose gross LTD benefit is $2,750 and who is receiving Social Security disability benefits of $1,750 per month. Her net LTD benefit of $1,000 may be payable up to age 65, the policy’s maximum benefit age. The value of net benefits to age 65 is $240,000 ($1,000 per month times 240 months).
For this claimant, the Social Security disability income benefit of $1,750 per month is not taxable. Under Internal Revenue Code Section 86, an individual taxpayer’s Social Security benefits are subject to tax if the taxpayer’s total income, including half of the Social Security benefits, does not exceed $25,000. In this example, even if the taxpayer was receiving her $1,000 per month LTD payment, the Social Security benefits would still not be taxable. That is because one-half of her Social Security benefits plus $1,000 per month in LTD income would be $22,500, which is less than the $25,000 floor. In fact, the taxpayer’s total tax bill would be zero because the $12,000 in LTD benefits she received is less than the current standard deduction $12,000 that may be claimed by single persons.
Thus, if the claimant wins her lawsuit, her Social Security and monthly LTD benefits would be non-taxable. In contrast, assume the claimant settles her LTD lawsuit for $120,000, half of the value of back and future benefits. Under current tax law, she would be taxed on 100% of her LTD settlement and 85% of her Social Security benefits. The federal tax on $137,850 of gross income would be $24,441. North Carolina does not tax Social Security disability benefits, but the LTD settlement payment would result in $6,300 of state tax. Thus, a total of $30,741 of federal and state income taxes would be incurred as a result of the $120,000 settlement.
When discussing settlement of an LTD claim, either in the context of a buy-out offer or the settlement of a court case, LTD insurers typically present a calculation that reduces the stream of future benefits to present value. The discount factor applied by the carrier is typically 4% to 5%. The discounting of future benefits makes sense in the abstract. No one can argue with the general proposition that “a dollar today is worth more than a dollar in the future.” The idea is that a claimant can earn a return by investing the lump sum settlement. Discounting can make a huge difference in the value of the claim when the claimant is young. In the example noted above, using a rate of 5% per annum reduces the $240,000 of benefits for this 45-year-old claimant to $151,525. In settlement discussions, insurers present the discounted amount as the maximum case value and try to convince the claimant that her opening offer should be below that number.
The claimant is not required to accept the insurer’s 5% discount rate. If the justification for discounting is the earnings the claimant can earn from investing settlement funds, one must consider the rate of return the claimant could realistically earn on a safe investment. One-year certificates of deposit are currently paying around 2.7% per annum. Five-year CDs, 3.1%. However, interest on CDs is taxable. If a claimant has a combined federal and state income tax rate of 25%, the after-tax yields on the one-year and five-year CDs are 2.03% and 2.33%, respectively. A good argument can be made that a discount rate should be no greater than the after-tax rate of return offered by CDs or Treasury securities. In the example discussed above, using 2% rather than 5% for the discount rate results in a present value of $197,674.
Clients should be made aware of the adverse tax consequences of settlements. When negotiating with disability insurers, it is important to challenge the insurer’s present value calculation. In many cases, such as the example cited above, discounting a claim to present value makes no sense at all. Because of the tax bite, a taxable dollar received today may be worth far less than a non-taxable dollar received in the future. At a minimum, the income taxes the claimant will incur by settling should be considered in evaluating whether to settle or fight.
© Andrew Whiteman 2019
Whiteman Law Firm specializes in cases involving claims for disability insurance and other employee benefits. These cases typically involve application of a federal law, the Employee Retirement Income Security Act of 1974, known by the acronym ERISA, and are usually resolved through the benefit plan’s appeal process or federal court. We have helped hundreds of individuals with their claims for short-term and long-term disability insurance benefits.
Contact us for more information about our ERISA disability benefits practice.