The Internal Revenue Service (IRS) taxes disability insurance benefits from individually owned policies as well as group- and government-sponsored plans. The determining factors of taxing disability payments depend on the insurance plans and how they are funded or how much the applicants earn. The amount of disability benefits that is considered taxable compensation is over 80 percent in some cases.

About Disability Insurance

Disability insurance protects the insureds' incomes by paying benefits while they are out of work due to injuries or illnesses. There are two main types of disability plans available: Short-term and long-term disability. Short-term disability (STD) generally pays benefits ranging from a couple of weeks up to two years, according to the Insurance Information Institute, while long-term disability (LTD) pays for two years and longer. Benefit amounts vary from insurer to insurer, but most STD and LTD plans cover about 60 percent of the insureds' earnings. No disability policies will cover 100 percent, otherwise there wouldn't be any incentive for individuals to get back to work.

About Social Security Disability

The Social Security Administration, a federal government agency, runs a disability program as well. Disability payments from this program are entitled to all American citizens who meet the agency's criteria of disability: medical conditions that last longer than a year and prevent individuals from doing work they were previously employed for. This program doesn't cover short-term or partial disabilities. Benefit amounts depend on how much the workers paid into Social Security and their lengths of employment. Each eligible worker is notified each year of how much he could expect in Social Security payments if he were to become disabled.

Taxation of Disability Payments

The IRS taxes individual and group-sponsored disability benefits based on how the insurance premiums are paid. If premiums are satisfied with pretax dollars, then benefits paid from those disability plans are considered taxable incomes. However, disability coverages funded with after-tax dollars will pay out tax-free benefits. Group plans are typically funded with pretax dollars while money previously taxed is used to pay individually owned disability policies.

Taxation of Social Security Disability Payments

The taxation of Social Security Disability benefits is based on the amount of the individuals' incomes as well. For example, individuals who have combined incomes, including payments from Social Security Disability, of over $25,000 will have their benefits taxed. Between $25,000 and $34,000, about 50 percent of the benefits are taxed by the IRS. Combined incomes of over $34,000 will result in up to 85 percent of the disability benefits being subject to taxation. For married couples, taxation of their benefits begins when their combined incomes cross $32,000. Incomes between $32,000 and $44,000 will result in 50 percent of the disability benefits being taxed and up to 85 percent for earnings over $44,000. Disability benefits are taxed at normal tax rates found on 1040 and 1040A forms.