What Really is Taxable Third-Party Sick Pay? Avoid this Mistake + FAQs

Taxable third party sick pay is any sick leave or disability wage paid by someone other than your employer (like an insurance company) that the IRS considers taxable income just like regular wages.

According to a recent industry study, over 80% of U.S. workers don’t fully understand their disability benefits, risking costly tax mistakes and surprise IRS bills.

Many employees and even employers are unsure how third party sick pay works. This comprehensive guide will demystify the topic.

In this guide, you will learn:

• 💡 What “third party sick pay” means and why some of it is taxable – explained with real-world scenarios.

• 🏛️ How federal tax law (IRS rules) treats third party sick pay and who is responsible for withholding taxes.

• 🌎 Differences across all 50 states in taxing third party sick pay, summarized in a handy state-by-state table.

• ⚠️ Common mistakes to avoid when handling third party sick pay (to prevent penalties and headaches).

• 🔍 Key terms, forms, and comparisons – from Forms W-2 & 8922 to how third party sick pay stacks up against workers’ comp, Social Security disability, and more.

Let’s dive in to understand this often misunderstood topic in full detail.

What Is Taxable Third Party Sick Pay? (Direct Answer & Federal Overview)

Taxable third party sick pay refers to payments you receive when you’re unable to work due to sickness or injury, paid by a third party like an insurance company or state disability fund, which are considered taxable income under law.

If an entity other than your direct employer pays you sick leave or disability benefits, those payments can be taxed just like your normal paycheck – provided certain conditions are met.

The IRS defines “sick pay” as any amount paid to an employee for time when they cannot work due to illness or injury. When your employer has a plan (often an insurance policy) that pays you through a third party (for example, a disability insurance company), that third party becomes the payer of your benefits.

If your employer paid the premiums for that policy (or let you pay premiums pre-tax), then the benefits you get are generally taxable. They count as part of your income, and the IRS expects you to pay income tax on them – and even payroll taxes like Social Security and Medicare in many cases.

On the other hand, if you paid the insurance premiums yourself with your own after-tax dollars (for instance, a voluntary disability plan you bought or contributed to without any pretax benefit), the situation flips. In that case, the benefits you receive are typically not taxable income.

It’s similar to how insurance works: if you pay the cost of coverage out of pocket, the payout is tax-free. But if someone else (your employer) foots the bill for your coverage, the IRS treats the payout as part of your compensation, which makes it taxable.

Key takeaway: Third party sick pay is taxable when it’s coming from a benefit that was funded by pretax or employer dollars. This includes most employer-provided short-term or long-term disability plans. Conversely, if you paid the full premium with post-tax money, then the sick pay you get is usually tax-free.

Why “Third Party” Matters

The term third party is used because a party other than you (the employee) or your direct employer is involved in paying you. Common examples of third-party payers are insurance companies (like Aflac, MetLife, The Hartford, etc.) or government-run disability programs (like state disability insurance funds). They step in to send you checks when you’re out of work on disability or extended sick leave.

From a tax perspective, this third-party arrangement introduces extra complexity. Normally, when your employer pays you, they handle all the tax withholdings and reporting on your paycheck. But with a third party, special IRS rules determine who withholds taxes and how it gets reported on forms like the W-2. The IRS essentially says: “If that sick pay is taxable, we still want the taxes—so someone must withhold and report them.”

Under federal law, third party sick pay is often treated as if the employer paid it. The IRS allows the employer and the insurance company to decide who will take on the tax responsibilities. There are two common setups:

1. Third party as an agent of the employer: In this arrangement, the insurance company (or third party) acts just like the employer’s payroll department. They withhold income tax, Social Security, and Medicare from the payments and later hand all the info to the employer. The employer then includes those sick pay amounts on the employee’s Form W-2 along with regular wages. Essentially, the employer handles reporting, and the insurance payout is seamlessly merged into payroll records.

2. Third party not as agent: Here, the insurance company takes on more of the duty. They withhold Social Security and Medicare taxes (since those are required by law for wage payments), and they might withhold federal income tax if you, the employee, requested it on a W-4S form (withholding for sick pay is optional unless the employee asks).

3. At year-end, the insurance company issues you a Form W-2 for the sick pay they paid out, separate from your employer’s W-2 for regular wages. On that W-2, there’s a special checkbox labeled “Third-party sick pay” (in Box 13) indicating that this is a third party payment. The employer, in this case, does not include those amounts on their own payroll tax returns for income tax withholding, but they still might need to handle the employer side of payroll taxes (more on that shortly).

In both cases, the money you got from the insurer is considered taxable wage income to you if the premiums were employer-paid. The difference is just who reports it and how. The IRS has designed this to ensure that all taxable sick pay gets reported somehow, without double counting.

Tax Withholding and Payroll Taxes on Sick Pay

A critical detail about taxable third party sick pay is that it’s subject to payroll taxes (FICA – Social Security and Medicare taxes), but not indefinitely. Here’s how it works:

• During the first six months after the last month you worked, any sick pay you receive is subject to Social Security and Medicare taxes, just like a regular paycheck. This means the third party payer will withhold 6.2% for Social Security and 1.45% for Medicare from your benefit (the same amounts that normally come out of your wages), and your employer (or the third party on the employer’s behalf) will pay the employer’s matching share of those taxes.

• After six months have passed since you last worked, subsequent sick pay is no longer subject to Social Security or Medicare taxes. The rationale is that after a long absence, those payments aren’t treated as wage income for FICA purposes (though they might still be subject to income tax). This six-month rule is important because it means long-term disability benefits often stop accruing Social Security credits after six months – something disabled workers might not realize.

For example, if you went on disability leave in January and haven’t returned to work by the end of June, any payments you get starting in July (month 7 of absence) would not have Social Security/Medicare tax taken out. You’d notice a bit more in your check, but also keep in mind you wouldn’t be paying into Social Security for that period.

Federal income tax withholding on third party sick pay works a bit differently. Unlike regular wages (where employers must withhold federal income tax), an insurer or third party isn’t required to withhold income tax from disability payments unless you actively request it. You can do that by submitting Form W-4S (a special form to ask for withholding on sick pay) or an equivalent method with the payer. If you don’t request it, you might receive your benefits with no federal income tax withheld – which can lead to a surprise tax bill if you don’t make estimated tax payments. Many recipients don’t realize this and think “no taxes taken out” means it’s tax-free, which is a costly mistake. 💡 Tip: If you expect your sick pay to be taxable, consider requesting withholding or setting aside money for the IRS.

Reporting and Forms: W-2, 1099, and 8922

When tax time comes, reporting third party sick pay involves a bit of coordination:

• Form W-2: Taxable sick pay generally gets reported on a W-2 form, because it’s considered wage income. If the insurer (third party) was not acting as agent for the employer, the insurer will issue a W-2 showing the sick pay amounts: typically, Box 1 (Wages) will include the taxable amount, Box 3 and 5 will show amounts subject to Social Security/Medicare (if within six months), and Box 13 will have the “Third-party sick pay” checkbox checked. If some or all of the sick pay was not taxable (because you paid those premiums), the insurer might issue a W-2 with $0 in taxable wages but an amount in Box 12 with Code J.

• Code J stands for “nontaxable sick pay” – essentially telling the IRS and Social Security Administration (SSA) that “this person got $X of sick pay that was not taxed.” That way, the SSA knows not to count that $X as earnings for Social Security benefit calculations, and the IRS knows why you didn’t include it as income.

• Form 8922 (Third-Party Sick Pay Recap): This form is one most employees never see, but it’s crucial behind the scenes. Form 8922 is used by the employer or the insurance company (or both) to reconcile who paid the Social Security and Medicare taxes on the sick pay and who reported the income. Why is this needed? Suppose an insurer pays you $10,000 in taxable sick pay for the year.

• They withhold your share of Social Security/Medicare and maybe send a W-2 to you. Meanwhile, your employer might still need to pay the employer’s share of Social Security/Medicare on that $10,000. If both the insurer and the employer file their quarterly tax returns (Form 941) including that $10,000 in wages, the SSA could think you earned $20,000.

• To prevent such discrepancies, Form 8922 is filed once a year to line up the numbers – essentially telling the IRS/SSA “We paid out $X in third-party sick pay for this employee; the insurer reported $Y and the employer reported $Z, and together they account for the correct total.” It’s a recap that ensures your earnings record and tax payments match up correctly.

• 1099 Forms: In some cases, certain disability payments might be reported on a Form 1099 instead of W-2. This typically happens if the payment isn’t considered “wages” at all. For example, under new Paid Family Leave programs in some states, benefits for family leave (to care for a family member) might come on a 1099-G or 1099-MISC because the IRS views them differently (not your own sickness wages, so not reported as wages). However, for classic third party sick pay (your own disability/sickness benefits), a W-2 is the norm when taxable.

The bottom line is that taxable third party sick pay blurs the line between payroll and insurance. The IRS has a system where either the employer or the third party (or both in tandem) take on the withholding and reporting duties so that from the government’s perspective, nothing falls through the cracks.

As an employee, you just need to know that if you’re getting disability or sick leave payments from an insurer, you should watch for a W-2 from either that company or your employer. Don’t ignore it, because it likely has income you must report on your tax return.

State Taxation of Third Party Sick Pay: 50-State Overview

Federal law is only part of the story. State taxes can also apply to third party sick pay, and each state can have its own twist. In general, most states follow the federal treatment: if the sick pay is taxable federally, it’s taxable for state income tax purposes too (for states that have an income tax). However, some states have special programs or rules that change the picture for disability benefits.

A number of states operate their own state disability insurance or paid leave programs. These programs collect contributions (often through payroll deductions) and pay benefits to workers who can’t work due to disability or family leave. The tax treatment of those benefits can vary:

• States like California, New Jersey, and Rhode Island do not tax the benefits paid from their state disability programs. If you live in one of these states and receive state disability insurance (SDI in California, Temporary Disability Insurance in NJ and RI), those benefits are exempt from state income tax. (They’re often funded by employees’ own contributions.)

• States like New York and Hawaii have employer-mandated disability plans where both employers and employees may contribute. These states partially tax the benefits: the portion of your disability benefit that is attributable to your employer’s contributions is taxable by the state, while the portion from your contributions is not.

• Newer paid family and medical leave states (such as Massachusetts, Washington, Connecticut, Oregon, Colorado, and others) generally follow a similar principle. If the benefit comes from employer-paid contributions, it’s taxable; if from employee-paid, it’s not. Many of these states allow or require withholding on their paid leave benefits to help you cover any tax due.

It’s a patchwork of rules, so it’s best to see specifics. The table below summarizes how each U.S. state treats third party sick pay or disability benefits for state income tax:

(Note: The above focuses on state income tax. States also have different rules for state unemployment insurance taxes regarding third party sick pay – for example, typically employers include those payments for unemployment tax purposes – but those details affect employers more than individual recipients.)

As you can see, most states stick to the federal baseline: they will tax your third party sick pay if it was funded by your employer. A handful of states make an exception for their own state-mandated disability programs, often treating those benefits as tax-free to encourage participation or because employees directly pay for coverage.

Common Mistakes to Avoid with Third Party Sick Pay

Even experts can slip up when dealing with third party sick pay. Here are some common mistakes to watch out for and avoid:

• ⚠️ Assuming “no withholding” means “no tax” – If you notice your disability checks had no income tax taken out, don’t assume the money is tax-free. Many people spend the entire benefit and then get a tax bill in April. Remember: if your employer paid the premium, the IRS still expects income tax, even if it wasn’t withheld upfront.

• ⚠️ Failing to report the income – Some taxpayers simply omit the W-2 from the insurer on their tax return, especially if it shows only “Third-party sick pay” and they’re unsure what it is. This is a big no-no. The IRS receives a copy of that W-2; leaving it off your return can trigger a letter or audit. Always include any taxable sick pay as income on your 1040.

• ⚠️ Employers double-reporting or not reporting – On the employer side, a frequent error is to either double count the sick pay on payroll reports or not report it at all. If the employer and insurer don’t coordinate, the employee’s Social Security earnings record can get messed up. Employers should use Form 8922 to reconcile who paid what. Failing to do so could mean an employee’s earnings are overstated or understated with the SSA.

• ⚠️ Missing the 6-month cutoff for FICA – Payroll departments sometimes keep withholding FICA taxes on disability payments beyond the six-month mark. This is a mistake; after six months, those benefits shouldn’t have Social Security/Medicare taxes taken out. Over-withholding can shortchange the employee and complicate corrections later. Conversely, some fail to withhold FICA during the first six months when they should, which can lead to IRS penalties for the employer.

• ⚠️ Not distinguishing taxable vs. nontaxable portions – When an employee has partially contributory coverage (say the employer and employee each paid 50% of the premium), the benefits are partly taxable. A common error is to treat the entire benefit as taxable (or entirely non-taxable). The correct approach is to calculate the portion attributable to employer funding and only tax that portion. Misallocating this could mean overpaying or underpaying taxes. For example, if 50% of the premium was employee-funded post-tax, then half of the benefit is tax-free – failing to exclude that half means the employee pays unnecessary tax.

• ⚠️ Ignoring state tax differences – People often focus only on federal tax and forget state rules. For instance, Californians might report their state disability income on a CA tax return when they actually shouldn’t (it’s exempt), or conversely, a New Yorker might not realize a portion of their disability benefit is taxable in NY. Always double-check your state’s stance (use the above table as a guide).

• ⚠️ No Form W-4S submitted – Many employees don’t know about Form W-4S (or the option to have tax withheld from sick pay). Not submitting it means you get no income tax withheld. If you end up owing a large amount, you could also face an estimated tax underpayment penalty. Avoid this by planning ahead: either file a W-4S with the insurer to have say 10% or 12% withheld, or make quarterly estimated tax payments on the benefit.

By being aware of these pitfalls, both employees and employers can save themselves a lot of trouble. ✅ Pro tip: If you’re an employee receiving third party sick pay, keep communication open with both the payer and your employer’s HR/payroll. Ensure everyone knows who’s doing what for taxes. If you’re an employer, have a clear agreement with the insurer about responsibilities, and always perform year-end checks (including that Form 8922 filing if needed).

Key Terms and Glossary

Understanding third party sick pay means getting a handle on some jargon. Here’s a quick glossary of key terms and entities:

Detailed Examples and Scenarios

To make all these rules more concrete, let’s walk through some real-life scenarios. Below are three common situations with breakdowns of how taxes and reporting work in each:

Example 1: Employer-Paid Disability Plan (Fully Taxable Benefit)

Scenario: Jane works for XYZ Corp, which provides a company-paid short-term disability plan. XYZ Corp pays 100% of the insurance premium for this coverage – Jane doesn’t contribute at all. Unfortunately, Jane has a serious injury and goes on disability leave. The insurance company (a third party) starts paying her a benefit equal to 60% of her normal wages, which comes out to $3,000 per month.

Since XYZ Corp paid the premiums, the benefits Jane receives are fully taxable as income. They are essentially part of her compensation package. Here’s how the details break down:

How it looks to Jane: Come tax time, Jane gets a W-2 from the insurer reporting $36,000 of wages. She must include that on her tax return. Because no income tax was initially withheld, she may owe taxes on that $36k. If she’s in the 22% federal tax bracket, that’s about $7,920 in federal tax. Thankfully, after a few months she did request withholding, so by December some tax was withheld to cover part of it. She also notices FICA was withheld for half the year, which is normal. Her employer’s payroll did not mix this into her regular W-2, because the insurer handled it.

Example 2: Employee-Paid Voluntary Disability Policy (Tax-Free Benefit)

Scenario: Carlos has a voluntary long-term disability (LTD) insurance policy through his company, ABC Inc. The premium for this LTD policy is deducted from Carlos’s paycheck each month as a post-tax deduction (meaning, ABC Inc. takes the money out after calculating taxes on his salary). Essentially, Carlos is paying for his own disability insurance with his already-taxed income. Fast forward, Carlos develops a serious medical condition and goes on LTD, receiving benefits equal to 50% of his salary, which is $2,500 per month.

Because Carlos paid the premiums with post-tax dollars, the LTD benefits he receives are 100% tax-free. It’s like receiving an insurance payout on a policy you paid for yourself.

Here’s the breakdown:

How it looks to Carlos: At tax time, Carlos gets a W-2 with Code J showing $30,000. He doesn’t include that $30,000 in income. There’s no additional tax burden from the disability payments – a relief financially while he’s dealing with illness. Essentially, because he bore the cost of insurance, he’s getting the benefit free of tax. (It’s worth noting he also didn’t get a tax break on the premiums when he paid them, since they were post-tax. It evens out: pay tax on the premiums, no tax on the benefits.)

Example 3: Shared Cost (Employer & Employee Each Paid Part of Premium)

Scenario: Lisa’s employer, Acme Co., offers a group disability plan but splits the cost with employees. Acme Co. pays 50% of the premium, and employees pay the other 50% via after-tax payroll deductions. Lisa unfortunately needs to go on disability leave, and the plan pays her a benefit of $4,000 per month (which is a portion of her normal pay).

In this shared scenario, part of Lisa’s benefit is taxable and part is tax-free. Since the employer paid half the premiums, half of each benefit payment is attributable to employer funding (taxable). The other half is from Lisa’s own contributions (post-tax), so that portion is not taxable.

Here’s the breakdown:

How it looks to Lisa: Lisa’s disability pay isn’t a tax-free windfall, but it’s not fully taxable either – effectively, she’s taxed on half of it. If she’s in the 22% bracket, and assuming the full year on disability, she’ll owe tax on $24,000, which is about $5,280 in federal tax. The other $24,000 has no income tax. Throughout the year, FICA was only taken out on half her benefit (so 7.65% of $2,000 each month). At year-end, Lisa uses the W-2 to report her taxable sick pay. She also makes sure not to pay tax on the Code J amount, since that’s her own funded portion coming back to her.

These examples cover the most common scenarios: fully employer-paid (fully taxable), fully employee-paid (tax-free), and a mix. Regardless of scenario, notice that whenever there’s a taxable component, the third party and employer have to coordinate on tax withholding and reporting. The concept of “taxable third party sick pay” always ties back to who paid for the benefit in the first place.

Evidence and Data: The Importance of Third Party Sick Pay

Third party sick pay isn’t a niche issue – it affects a significant number of workers and dollars in the economy. Here are some eye-opening facts and figures:

• Prevalence: Approximately 5% of working Americans experience a short-term disability (lasting six months or less) each year. That means millions of workers annually may receive disability sick pay for at least some period.

• Long-Term Risk: About 25% of today’s 20-year-olds will suffer a disability that keeps them out of work for a year or more before they reach retirement. In other words, one in four workers will likely rely on disability income at some point – highlighting how common this can be over a career.

• Employer Coverage: The vast majority of full-time workers have some access to sick leave or disability insurance. Around 40% of civilian workers have short-term disability coverage and ~35% have long-term disability coverage through their employers. Importantly, employers pay all or part of the premiums in roughly 85% of disability insurance plans (about 38% of employers pay the full cost, 47% split the cost with employees). This means most disability benefits received are at least partially taxable, due to employer involvement.

• Benefits Paid: In 2023, private U.S. insurance companies paid out over $150 billion in disability benefits (and related accident/health benefits). This staggering figure shows how much money flows through these income replacement programs. A significant portion of that ends up being taxable income to recipients. Add to that the billions paid by government programs like Social Security Disability Insurance (about $150 billion annually), and you can see the scale of disability-related income.

• Lack of Awareness: Despite these big numbers, knowledge is low. Only about 20% of workers consider themselves very knowledgeable about disability insurance. In a survey, over 40% of employees with disability coverage admitted they did not understand their own coverage. This lack of understanding extends to tax treatment – it’s a confusing area. No wonder so many people are caught off guard at tax time regarding their sick pay.

• Compliance Challenges: The IRS created Form 8922 in 2014 to specifically address third party sick pay reporting. Each year, thousands of these forms are filed by employers and insurers to reconcile wages. It’s an indicator that misreporting was common enough to need a formal fix. Moreover, payroll tax experts rank third party sick pay reporting as a frequent pain point – it’s often listed among common payroll mistakes that companies must watch for.

• Social Security Impact: Taxable sick pay that has FICA withheld counts toward an individual’s Social Security earnings. This can be vital for someone who becomes disabled early in their career – those taxed benefits might help them qualify for Social Security Disability or later boost their retirement benefit. However, once the FICA stops after six months, those later benefits do not count for Social Security. It’s a nuanced impact: in the short term, it helps keep earnings records consistent; in the long term, prolonged disability can mean lower lifetime earnings recorded.

These data points underscore why understanding taxable third party sick pay is so important. It’s not just a trivial HR box-checking exercise – it affects workers’ wallets, government revenue, and even future benefits like Social Security. Both employees and employers benefit when this topic is handled knowledgeably: employees avoid surprises and get every dollar they’re entitled to, and employers stay compliant and keep their workforce informed.

Comparing Third Party Sick Pay to Similar Taxable Benefits

It’s helpful to put third party sick pay in context with other types of benefits or income you might receive when you can’t work. Let’s compare it with a few related concepts:

Third Party Sick Pay vs. Regular Employer-Paid Sick Leave

If you take a normal paid sick day or two and your employer just continues your regular salary, that isn’t third party sick pay – it’s just your normal wages. Tax-wise, regular sick leave is simple: it’s fully taxable as ordinary wages and subject to all withholding, just like any work day.

In contrast, third party sick pay usually kicks in for longer absences when an insurance policy starts paying instead of your employer. From the employee’s perspective, both regular sick leave and third party sick pay put money in your pocket when you’re out sick, but with a third-party insurer involved, the tax reporting becomes a special case (with those W-2 checkboxes, etc.). Think of it this way: one is just your boss paying your sick day, the other is an insurance benefit paying your salary replacement – and the latter comes with extra tax wrinkles.

Third Party Sick Pay vs. Workers’ Compensation

Workers’ compensation is a separate system for job-related injuries or illnesses. If you get hurt on the job, workers’ comp insurance (often required by law) pays you benefits. A key difference: Workers’ comp benefits are generally tax-free. The IRS explicitly excludes workers’ comp from taxable income because it’s compensation for workplace injury. So, if you’re out due to a work injury and get workers’ comp, you won’t owe taxes on those payments, and no Social Security or Medicare taxes come out of them either.

Third party sick pay, on the other hand, usually involves non-work-related disabilities (like a sickness or injury outside of work). If your employer paid the premiums, those benefits are taxable and treated as wages. Another difference: workers’ comp is typically mandated and handled through state-regulated insurance, whereas third party sick pay via private disability insurance is optional or offered as a benefit for off-the-job issues. In summary, both workers’ comp and third party sick pay replace lost wages during an injury/illness, but one is tax-free (workers’ comp for job injuries) and one can be taxable (sick pay for non-work disabilities).

Third Party Sick Pay vs. Unemployment Benefits

Unemployment benefits (UI) provide income if you lose your job and are actively looking for work. They are taxable income at the federal level (you’ll get a Form 1099-G for unemployment comp), but notably, they are not subject to FICA taxes. You don’t pay Social Security or Medicare tax on unemployment checks. Many states tax unemployment benefits as well, though some states do not.

Third party sick pay is different in that you’re still technically employed (just on leave) and the income is coming from a disability insurance plan, not a state unemployment fund. If your employer contributed to your disability coverage, then that sick pay is taxable wage income (reported on a W-2) and FICA taxes apply for a time. The similarity is that both UI and sick pay are forms of income replacement; the difference is why you’re not working (job loss vs. illness) and the tax handling. Also, receiving third party sick pay usually means you’re not “able and available” to work, which means you generally can’t collect unemployment simultaneously. In short: UI is taxable (federally) but no Social Security tax, whereas third party sick pay is taxable if employer-funded and does have Social Security/Medicare tax withheld initially. And each comes from a different program (state unemployment vs. private/state disability insurance).

Third Party Sick Pay vs. Social Security Disability (SSDI) and SSI

Social Security Disability Insurance (SSDI) is a federal program that pays benefits if you have a long-term disability and can’t work, provided you have enough work credits. SSDI benefits can be taxable but only if you have other income or a higher total income (similar to Social Security retirement benefits – depending on your income, up to 85% of SSDI benefits might be taxable, while those with low income pay no tax on SSDI). Importantly, SSDI payments are not considered earned income – they are not wages and not subject to payroll taxes, and they don’t count toward things like IRA contribution eligibility or the Earned Income Credit.

Third party sick pay, on the other hand, is considered wage income (when it’s taxable) and counts fully as earnings in the year you receive it. Also, SSDI often kicks in after other benefits are exhausted; many private long-term disability plans require you to apply for SSDI and will offset what they pay by what SSDI pays. SSI (Supplemental Security Income) is another federal program (needs-based) for disabled individuals with very low income – SSI benefits are not taxable at all.

So comparing: third party sick pay is typically short-to-medium-term wage replacement from an insurer or employer plan (taxable as wages if employer-backed). SSDI is long-term disability income from the government (taxable in a limited way like other Social Security benefits, but not treated as wages). SSI is a disability assistance program (completely tax-free). If you transition from private sick pay to SSDI, the taxation and reporting switch from W-2 wages to Social Security benefit rules – a big change to be aware of.

Third Party Sick Pay vs. State Paid Family and Medical Leave

In recent years, some states launched Paid Family and Medical Leave (PFML) programs. These provide paid time off for similar reasons as disability insurance – your own serious health condition (essentially short-term disability) or family caregiving leave. The distinction is that these are state-run programs, not private insurance, but tax-wise they function a lot like third party sick pay. If your employer contributes to the state fund, that portion of benefits is taxable. If only employees contribute, benefits might be tax-free. Many of these state programs allow you to elect tax withholding on the benefits.

The IRS has started treating many state medical leave benefits as equivalent to third party sick pay paid by a party that is “not an agent of the employer.” In practice, you might get a 1099-G or a W-2 from the state program depending on the type of leave. For example, Massachusetts’s PFML will offer a Form 1099-G for family leave benefits (not taxable wages) but treats medical leave benefits (for your own disability) more like sick pay with optional withholding and wage reporting.

In essence, think of state PFML benefits as a cousin to third party sick pay: if any employer money is in the mix, it’s taxable wage replacement; if purely employee-funded, it’s not taxed (at least federally). Each state program has its nuances, but from a federal standpoint, the treatment is aligned with the same principles as other sick pay.

Pros and Cons of Third Party Sick Pay

It’s helpful to evaluate the advantages and disadvantages of third party sick pay arrangements, especially in terms of taxation and administration:

FAQ: Frequently Asked Questions

Q: Is third party sick pay taxable income?
A: Yes. If your employer paid the premiums, the sick pay benefits are taxable (like regular wages). If you paid the premiums with after-tax dollars, those disability benefits are tax-free.

Q: Do I have to report third party sick pay on my taxes?
A: Yes. Report any taxable third-party sick pay on your return. If you receive a W-2 for sick pay, include those wages just like your regular income.

Q: Does third party sick pay count as earned income for IRA contributions or Earned Income Credit (EIC)?
A: Yes. Because it’s reported as W-2 wages, taxable sick pay counts as earned income for IRA contributions and the Earned Income Credit.

Q: Are disability insurance payments tax-free if I pay the premiums myself?
A: Yes. If you paid the disability insurance premiums yourself (after tax), the benefits you receive are tax-free.

Q: Do I need to pay Social Security and Medicare (FICA) taxes on third party sick pay?
A: Yes. Sick pay is subject to Social Security and Medicare (FICA) taxes for the first six months of disability. After six months, no FICA is taken out of those payments.

Q: Will I get a W-2 for third party sick pay, and who sends it?
A: Yes. Usually the third-party insurer issues a W-2 for your sick pay (marked “Third-party sick pay”). In some cases your employer does, but either way you’ll get a W-2 for any taxable payments.

Q: Do I have to file Form 8922 as an employee receiving sick pay?
A: No. Individual employees do not file Form 8922. It’s used by employers and insurers to reconcile third-party sick pay reporting between them.

Q: Is third party sick pay the same as workers’ compensation?
A: No. Workers’ comp (for job injuries) is usually tax-free, whereas third-party sick pay (for non-work disabilities) can be taxable if your employer paid the premiums. They are treated differently by the IRS.

Q: Can I choose to have taxes taken out of my disability payments?
A: Yes. You can have taxes withheld from your disability payments. Submitting Form W-4S to the insurer lets them withhold an amount each payment, so you won’t face a big tax bill later.

Q: If my disability benefit is partly taxable and partly not, will the W-2 show that?
A: Yes. The W-2 shows the taxable amount in Box 1 (and in the Social Security/Medicare boxes) and the nontaxable amount in Box 12 (Code J). It clearly separates the taxable and tax-free portions.