The design of most long-term disability plans can best be described as “too little too late,” leaving employees in an unfortunate but predictable situation.
Group long-term disability (LTD) plans can be non-taxable (employee-paid premiums resulting in non-taxable claim payments) or taxable (employer-paid premiums resulting in taxable claim payments). Canada Revenue Agency’s Interpretation Bulletin IT-428 makes it clear that employees must pay 100% of LTD premiums if claim payments are to be non-taxable. And this is a common strategy for employers: to have employees pay all of the LTD premiums, with the rationale that at least the payments will be non-taxable if employees ever need to claim LTD.
But is that good tax planning? Consider an employee who earns an annual salary of $100,000 ($8,333 monthly). The LTD plan could be set up so that the employee pays for a monthly benefit of 60% of gross monthly earnings (or $5,000) at a cost of $100 per month. Or, the plan could be set up so that the employer pays the LTD premiums and insures an extra $1,676 monthly (so that the employee would still have $5,000 in LTD monthly, after taxes) at a cost of approximately $134 per month.
Suppose the plan is employer-paid at a cost of $134 per month. The employer decides that, since the premium for non-taxable LTD is only $100, it would be better to give employees the $100 and have them pay the LTD premiums. However, based on 2008 Ontario tax rates, the employer would have to pay approximately $175 monthly for the employee to receive $100 in take-home pay. Either the employer pays the employee considerably more than the current $134 or the employee won’t have enough take-home pay to cover the LTD premiums.
Employee after-tax contributions to LTD premiums also come into question. LTD benefits can be designed to defer taxes and pay them at a lower marginal tax rate at the time of the claim. But unlike many tax-deferral plans, such as registered retirement savings plans, employees may never draw on LTD benefits. If no claim is made, it’s possible to be insured for LTD throughout one’s entire career, yet avoid paying taxes on the benefits. However, non-taxable LTD benefits can be a good fit when employees would be limited by a low maximum or a non-evidence maximum, when the insured group has significant sources of taxable non-employment income or when employees are already required to pay a large portion of benefits premiums.
Interestingly, LTD plans are calculated as a percentage of gross pay as reported by the plan sponsor, yet the maximum claim payment is measured as a percentage of take-home pay by the insurer. Non-taxable LTD plans should be using dynamic formulas that track income tax rates so that the benefit relates to the desired take-home pay level. Instead, the industry tends to use off-the-shelf graded formulas designed to generate approximately 85% of take-home pay. Employer-paid LTD benefits, on the other hand, typically insure 67% of gross earnings, producing about 75% of take-home pay after taxes. Why aren’t LTD formulas for both non-taxable and taxable plans designed to generate the same level of take-home pay?
Even more challenging is the fact that employees don’t really understand LTD benefits, let alone the tax implications. Employees who are insured for 60% or 67% of gross earnings think that’s what they’ll receive if they make an LTD claim. However, many group LTD plans ignore inflation, which has a direct impact on future purchasing power. For instance, a permanently disabled 40-year-old who is receiving 85% of take-home pay today will be left with only about 40% of that purchasing power at age 65 (assuming 3% annual inflation). For younger employees, the erosion by inflation is even more profound. An employer’s decision to exclude cost-of-living adjustments from the LTD plan design precludes employees from providing for their future financial security.
If employees understood that they could have the same purchasing power through employer-paid LTD—and that they could be financially better off that way—it would be far more difficult to persuade them to pay for it. When considering LTD benefits, employers should address the needs and wants of employees and use the dollars spent by both the employer and employees effectively—at the lowest possible cost, with the least amount of risk.
Dan Napier is a benefits consultant with Focus, an independent benefits consulting firm in Toronto.