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Tax Breaks for People with Disabilities

Special deductions, exclusions and credits apply

For the millions of disabled taxpayers in the country, the tax law provides financial assistance through special deductions, exclusions, and credits. The taxation of benefits received by disabled persons, however, is inconsistent and confusing.

Here's how it all works:

Social Security

• Social Security benefits paid because of disability may be partly taxable or totally tax free. Disability payments are treated like retirement benefits - they can be 50% or 85% taxable, depending on the taxpayer's other income.

• Supplemental Security Income (SSI) benefits paid to low-income disabled people are not taxed like Social Security benefits, even though they are also paid by the federal government. SSI payments of any amount are tax free.

Disability payments

• Workers' compensation. Payments for a job-related injury are tax free with no dollar limit. But payments for nonwork-related injuries are fully taxable.

If an employer continues to pay an injured employee's regular wages on the condition that the employee's workers' compensation payments be turned over to the company, then only the difference between the workers' compensation payments and the wages is taxable.

• Long-term-disability insurance payments. Some employees who become disabled receive payments under an employer-provided disability policy. These policies are often included in compensation packages as a tax-free fringe benefit. Other companies have cafeteria plans offering an array of benefits, including disability insurance that employees must choose from. The tax treatment of these benefits depends entirely on who paid the premiums:

If the employer paid, benefits are taxable.

If the employee paid, benefits are tax free.

Disabled children

• Supplemental needs trusts. Parents or guardians of a disabled child should have their lawyer set up a trust to provide the "extras" not covered by government programs. The trustee, which can be a person or an entity, such as a bank, has the discretion to disburse income and principal to pay minor expenses, such as the cost of a birthday party or to pay expenses not covered by government programs, such as special furniture, etc. Distributions used on the child's behalf are taxable income to the child. Presumably, the child will have little or no other income, so the disbursements from the trust effectively become tax free.

Caution: Leaving money directly to the child or leaving funds in any trust other than a supplemental needs trust could disqualify the child from receiving government benefits.

Education accounts

Generally, funds cannot be contributed to a Coverdell education savings account (ESA) after the beneficiary reaches 18, but there is no age limit in the case of a "special needs beneficiary." This is a person who, because of a physical, mental, or emotional condition - including a learning disability - requires more time to complete his education.

Similarly, funds accumulated in a Coverdell ESA generally must be distributed (or rolled over to another family member) by the time the beneficiary turns age 30. However, in the case of a special needs beneficiary, there is no age limit for completing distributions.

Medical expenses

Like nondisabled taxpayers, disabled ones may be able to deduct medical costs not covered by insurance. The expenses are deductible as an itemized deduction.

Limitation: Medical expenses can be deducted only to the extent that they exceed 7.5% of adjusted gross income (AGI).

• Home improvements. The cost of any modifications or additions to a home that are made in order to accommodate a disabled person are fully deductible as a medical expense.

For them, the deduction is not limited to the excess by which the improvement increases the value of a home, a limitation that generally applies to deducting home improvements as a medical expense.

Example: A disabled home owner installs entrance ramps and widens certain doors to accommodate his wheelchair. Regardless of whether these improvements add any value to the home, the entire amount is a deductible medical expense, subject to the 7.5%-of-AGI floor.

• Special schooling. Today, public schools are required to provide special assistance to children with physical and/or mental disabilities. If you choose a private school, however, all of your related costs can be treated as deductible medical expenses.

Example: A child who is hearing-impaired attends a school for the deaf to learn lip reading and sign language. The cost of his tuition is deductible, as well as room and board if boarding is required at the school.

• Employment-related plans. Parents of a disabled child may have medical expenses not covered by an employer plan. Check with the plan administrator to determine what kinds of expenses are covered and what substantiation is required for reimbursement.

Exemption for blindness

People who are totally or partially blind and who do not itemize their deductions can claim an additional standard deduction of $1,250 in 2005 ($1,000 if married and filing jointly). For this purpose, "blindness" is defined as sight that is 20/200 or less in the better eye with lenses, or as sight that has a field of vision of 20 degrees or less. The degree of blindness must be certified by a doctor.

Caution: This deduction does not apply to itemizers and there is no additional standard deduction for any other disability besides blindness.

work-related expenses

For some individuals, a disability is no bar to working, but there may be additional costs incurred to satisfactorily perform the job.

Example: Being accompanied on a business trip by a spouse or an aide. These added costs are deductible business expenses.

For self-employed individuals, the deduction is claimed on Schedule C.

For employees, the deduction is a miscellaneous itemized deduction listed on Form 2106, Employee Business Expenses, and then on Schedule A.

Tax break: Unlike other unreimbursed employee business expenses, these costs are fully deductible and are not subject to the 2%-of-AGI floor.

Retirement accounts

Disabled individuals can tap into their retirement accounts penalty free at any age - even under age 59 - 2 when others would have to pay a 10% early distribution penalty.

To qualify, the disability must be expected to last indefinitely, and it must prevent substantial gainful employment similar to the type of work being performed before the condition developed.

Long-term-care policies

For 2005, long-term-care insurance benefits of up to $240 per day (or the daily cost of the care, whichever is lower) are tax free to the disabled. If benefits are received on an annual basis, the 2005 limit is $87,600.

Free return preparation

Disabled individuals with income below $35,000 qualify for free tax return preparation assistance and free e-filing of returns. Volunteers under the IRS's Volunteer Income Tax Assistance (VITA) Program are trained in tax breaks for the disabled. To find a VITA program near you, call 800-829-1040.

Tax credits

There is a tax credit on the books for anyone under age 65 who is permanently and totally disabled - but income limitations are extremely low.

Example: The credit cannot be claimed by an unmarried individual receiving $5,000 or more per year in Social Security benefits. For details, see IRS Publication 524, Credit for the Elderly or the Disabled.

Employer credits: There are special credits that employers can claim to provide help to the disabled:

• Disabled access credit to provide access to the elderly and handicapped in compliance with the Americans with Disabilities Act (ADA).

• An employment credit to hire the disabled.

Note: This work opportunity credit is set to expire at the end of 2005, unless Congress extends it.