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If you are paying for a credit protection plan that will help you make payments if you become disabled or unemployed, you no doubt hope it will provide some peace of mind in the event you have to use it. But that peace of mind may be shattered when you learn that using it could result in an unexpected tax bill.

That’s what happened to our reader Asia. She said she’s been paying for credit protection for a while “When I went on maternity leave they made two monthly payments for me, which is part of the coverage of having the payment protection,” she wrote in an email. “After 90 days they paid off the balance of the card – $3,900.” She explains the plan benefits this way:

“In order to be eligible to claim the benefit you have to be out of work either permanently or because of a disability or family leave (birth of a child, adoption, etc.) once you claim the benefit they make your minimum payment for you, which is during a 90-day period, after the 90 days they pay the balance in full up to $10,000. I took a 6-month maternity leave approved by my job. The company requires paperwork from my employer and doctor confirming my leave and then they pay.”

Asia said she received correspondence that referred to a potential tax liability, but couldn’t get any specific information, despite several attempts to connect with the issuer and benefit provider.

That’s Income?

When most of us think of income, we think of paychecks or perhaps commissions. But the IRS definition encompasses a lot of other types of payments that most of us wouldn’t think are income, such as canceled debts. Are benefits received under a credit protection plan one of them?

The IRS website says this:

Credit card insurance. In most cases, if you receive benefits under a credit card disability or unemployment insurance plan, the benefits are taxable to you. These plans make the minimum monthly payment on your credit card account if you cannot make the payment due to injury, illness, disability, or unemployment. Report on Form 1040, line 21, the amount of benefits you received during the year that is more than the amount of the premiums you paid during the year.

Not so fast, says Edward Zollars, a CPA and partner with the tax practice of Thomas, Zollars and Lynch in Arizona.

“That is a disclaimer to cover themselves on the outside chance she somehow ended up with that protection paid for under some method when she could exclude income she received to pay the premiums from her income,” he wrote in an email.  “I’m not even sure *HOW* you could do that with a credit card plan, but I suppose it’s theoretically possible.”

What Zollars is referring to is the fact that generally consumers who get employer paid benefits like disability insurance usually have to include benefits they receive under those plans in their income. But when taxpayers pay for a disability insurance plan out of pocket, benefits typically aren’t taxed. (Even the Internal Revenue Service confirms this.)

“If we presume she just paid for the protection each month as part of her bill on the card then there’s not an issue,” he says.  “She got no tax benefit from paying for the protection (which is a form of short-term disability protection) so there’s no income when receives the payment.”

He compares that to employer-paid maternity leave. “Since you didn’t pay for the coverage out of pocket, nor is each employee charged with the value of such protection on each payroll when it’s not used, an employee ends up picking that amount up as income.”

Taxes & More Taxes

Of course this is the tax code we’re talking about, so things are rarely as simple as they may seem. Zollars pointed out a case that made it to U.S. Tax Court (Khen Thi and Hong Van Huynh v. IRS T.C. Summary Opinion 2001-131) where the IRS found that payments made by a credit card protection plan after the cardholder became unemployed were taxable. Part of the Tax Court’s argument was that “gross income includes income from discharge of indebtedness,” and that the couple purchased items with those credit cards and “received goods or services for these purchases and, therefore, realized economic benefits from such purchases. “

Zollars says that, “Obviously they are interpreting that (case) to go after disability insurance in that publication, though I don’t find any case where they have prevailed on the disability insurance aspect.”

That leaves Asia in a bit of a dilemma. The IRS may not find out that she received these benefits, but if they did, she would likely have to argue that they were disability benefits and therefore not taxable. “While I have my doubts about prevailing, it also would likely cost more to challenge than to pay in a case like that,” Zollars notes.

She can deduct the portion of the premiums she paid toward the benefit she received but even that’s tricky: She may have to determine “how much she paid for the disability coverage, separate from the unemployment coverage,” Zollars says.

Another Reason to Say No?

Consumer advocates often criticize these plans because they are expensive relative to the benefits provided, details in the fine print can make it difficult to collect, and overall very little in benefits is paid relative to the premiums paid. And now there may be another reason to think twice about getting this coverage: Benefits may be taxable.

Instead, try to pay down debt if possible. Of course that is often easier said than done, but the less debt you have, the less you’ll have to worry about if your income is interrupted. Need some incentive? Find out how your debt affects your credit scores. (You can do that by checking your truly free credit scores on Credit.com.) Paying down debt can often be beneficial to your credit scores and your wallet.

More on Income Tax:

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