Financial Planning 101 - Disability Insurance
Updated: Jan 29, 2020
I apologize for the long delay between installments but sometimes life gets in the way and I have been distracted with a few things recently, namely trying to train a new puppy that we picked up in April. That said, I am back with the final installment related to Insurance, this time dealing with Disability Insurance. Maybe not the sexiest topic in the world but one that is critically important to protect your family.
In the event of a long term injury or illness (think cancer, auto-immune, stroke, cardio vascular issues or injuries from a severe accident) which leave you unable to work for an extended period of time how does your family plan to continue to have money to pay bills? Even in families with two working spouses most families rely on both of those incomes to make ends meet. This is where Disability Insurance comes into play.
Some quick facts about disability insurance.
Workers in their 20’s have a one in four chance of experiencing a disability at some point so this is not as rare an occurrence as you might think.
While you may think you have a safe job and don’t need the coverage from an injury, 90% of claims are for illness and not injury.
Do you think men in labor jobs are most at risk? 60% of disability recipients are women.
41% of recipients are under age 50 and 33% are under age 40 so it is not just older workers at risk.
Finally, 51 million Americans do not have this type of coverage.
The goal of Disability Insurance is similar to life insurance in that its intention is to replace lost income. In the case of Disability Insurance though your income is replaced in the event of an injury or illness and not death. This article will cover the primary components of a policy, the amounts of coverage, and the tax consequences of policies.
Many employers will offer a short term disability policy that will continue to pay your salary in the event of illness or injury for a period of three to six months. Long term disability (LTD) can end up providing benefits for decades. This type of policy is often provided by employers as well but might come at a cost. Long term disability will be the focus of this post.
Some people may believe that Social Security will be their safety net if becoming disabled. About 70% of initial claims are rejected. Claiming these benefits can be a complicated and lengthy process. You must be deemed unable to perform any substantial and gainful work activity for a period of at least one year and even then it may take months or even several years before you start receiving benefits. The current maximum monthly benefit is $2,861 while the average benefit is $1,234. The benefit is based upon your income and not the severity of the injury or illness.
Components of Disability Policy
Elimination Period – This is the amount of time that has to pass before the policy has to begin paying benefits. Common time periods are 30 to 120 days but there are many options available. The longer the elimination period the lower the premium you pay. The elimination period you choose should align with how much you have in emergency savings.
Occupation class – This refers to the profession of the worker being insured. Each type of profession is assigned a class and the more likely a profession is to result in physical injury to the worker the higher the rates you’ll pay. There are five numbered classes and the lower the class number the riskier the profession. For example, lawyers and accountants are in classes 5 and 4, office workers would be in class 3, while manual labor jobs would be in class 1.
Definition of disability - This refers to the level of your disability needed before the policy benefits will be paid. The defined levels refer to the level of employment you are still capable of having as a result of the injury/illness.
Any occupation – This would mean that no benefits are paid as long as the worker is still able to hold any gainful employment potentially including unskilled low paying work. This would require pretty much total disability to get benefits.
Own occupation – With this policy definition benefits are paid if the policy holder is unable to do their current job duties. This can be especially important in higher paying jobs or a job that requires a specific skill. For instance, if a surgeon is in an accident and loses use of his hands but can still do plenty of other professions the surgeon would still receive benefits.
Tied to education, training and experience – This would mean benefits are only paid if the policy holder can no longer work in a field commensurate with their education, training and experience. Going back to our surgeon example, if the surgeon could no longer perform surgery but was capable of teaching med school they would not be eligible for benefits.
This is a major driver on the cost of the policy as a policy with ‘any occupation” is going to cost far less than an “own occupation” policy. Also, you want to make sure you get the coverage you need especially if you are in a higher paying profession where it is vital for you to protect your income.
4. Benefit Amount – This is the amount you will receive if you have a qualifying claim. This is tied to your income level and obviously the higher the benefit amount the higher the premium. If you seek a policy outside of your employer then you will have to provide some sort of proof of income.
Typically an employer plan may pay out at about 60% of your current salary. This is important to note depending upon how you are compensated. These policies will not cover compensation received from bonuses, overtime, deferred comp, stock options or other non-salary compensation.
Benefits received are usually reduced by other sources of disability income such as workers comp or Social Security. If you have both a personal policy and an employer provided policy the personal policy benefit will be reduced by the amount of the employer policy benefit.
Young workers in certain high paying careers (engineering, lawyer, medical fields for example) may also be able to get increased benefits based on projected earnings. This is an option that might be available to workers in their first couple of years in the field. There is a cap on the benefits they can receive but it is a higher benefit amount than if based on their current salary.
5. Benefit Length – This is the period of time you will continue to receive benefits from your policy. Generally policies will pay to your age 65 with the thought being that would be retirement age so there is no need to pay beyond that. There may be an option to receive benefits for a stated period of time such as 5 or 10 years. This might result in a lower premium but you could be at risk of losing benefits for a number of years if you select that option.
6. Policy Riders – These are options available to the policy holder that can be upgrades to the policy, of course for an additional fee. Examples include:Future Purchase – allows you to purchase additional coverage without undergoing a new medical evaluationInflation protection – Provides a benefit amount that increases each year by a couple percent to keep up with the cost of living.Waiver of premium – This allows the policy holder to no longer owe the premium while receiving the benefit.
How disability benefits are taxed
This comes down to who is paying the premium. In the event of a typical employer provided policy replacing 60% of your income, any benefits received will be taxable income for the recipient since the employer is paying the premium. Note that this reduces your real benefit to well below 50% depending on your tax bracket. Many employers might also offer the option to purchase additional LTD coverage and the benefits related to that portion of the policy will be tax free since the employee is paying the premium. Likewise, if you don’t have an employer provided policy and have an individual policy from an outside provider all of the benefits would be tax free since you are paying the entire premium.
Because the benefits from an employer plan are taxable it is important to get the additional coverage or you could be in for a disappointment when the benefits arrive.
Difference between group and individual policies
If you are covered through your employer for LTD this is known as a group policy. Group policies tend to have much lower rates because the risk for the insurance provider is spread over a large group of people. As stated earlier these types of policies generally replace 50-60% of your income and the benefits are taxable to the recipient. Individuals may have the option to purchase additional coverage usually up to a maximum of 66% of salary. This additional coverage is still considered a group policy even though purchased by the individual so the rates will be fairly low. The benefits received from this additional coverage will be tax free. One thing to note is that your coverage with these policies ends when you leave your job.
Individual policies can be purchased from a variety of insurance providers. These policies tend to be more expensive but do have a few nice features. Generally these policies seek to replace 50-70% of salary. First, they are guaranteed renewable meaning the policy stays in force as long as you pay the premiums. Next, the policy premium generally does not increase during the life of the policy whereas coverage through an employer can have a different rate each year. Lastly, as stated before, the benefits are tax free for the recipient.
I hope that sheds a little light on the topic of disability insurance for you. This is the last post related to insurance I will be doing and will now be moving on to investments. As always, if you have any questions or concerns about your personal finances related to this or any other topic please reach out to me for a free consultation at firstname.lastname@example.org or click here to schedule a no cost discussion.