Disability Insurance: Protecting Your Income When You Can't Work
Most of us insure our homes, cars, and other valuable assets. But during our working years, one of our most valuable assets may be something we don't always think about insuring: our ability to earn an income.
A serious illness or injury can affect much more than your paycheck. It can change your family's cash flow, increase medical and household expenses, interrupt retirement savings, and force you to use assets that were intended for other goals. Disability insurance is designed to replace a portion of your income when an illness or injury prevents you from working.
And disability may be more common than many people realize. According to Social Security Administration information, roughly 1 in 4 of today's 20-year-olds will become disabled before reaching full retirement age.
The Financial Impact of a Disability
When we think about losing income because of a disability, it's tempting to simply compare our current paycheck with the disability benefit we might receive. But the financial impact can be much broader.
Many of your regular expenses don't disappear because you aren't working. The mortgage, utilities, groceries, insurance premiums, and other household expenses generally continue. At the same time, some expenses could actually increase.
A disabling illness or injury could mean higher medical costs, deductibles and out-of-pocket expenses. You may need help with transportation, cooking, cleaning, lawn care, or other everyday tasks you previously handled yourself. Home modifications or medical equipment may also be necessary. Families with children could face additional childcare needs. And if a disability eventually causes you to leave your job, the cost of maintaining health insurance could become another significant expense.
Then there is the longer-term impact that isn't immediately visible. If income falls substantially, you may have to reduce or stop retirement plan contributions, use emergency savings, sell investments, or postpone other financial goals.
The question isn't simply, "Could I pay my bills for a few months?" It's also,
What would a prolonged loss of income do to the rest of my financial plan?
Start With the Coverage You Already Have
Before buying additional insurance, start by understanding what protection is already available to you.
Many employers provide short-term disability, long-term disability, or both. Short-term coverage is intended to bridge a relatively short period of lost income, while long-term disability coverage may continue for years or to a specified age.
Don't assume, however, that having disability insurance listed in your employee benefits means you're fully protected. Review the actual policy and ask:
- How much of my income would it replace, and is there a monthly benefit cap?
- Does the calculation include bonuses or commissions?
- How long is the waiting or elimination period before benefits begin?
- How long could benefits continue?
- How does the policy define "disabled"?
- Are partial disabilities covered?
- Would benefits be reduced by Social Security, workers' compensation, or other benefits?
- Can I keep the coverage if I leave my employer?
- Would the benefits be taxable?
Those details can make a significant difference in how useful the coverage actually is.
Group Coverage vs. Individual Disability Insurance
Employer-provided group insurance is often an excellent starting point. Premiums tend to be relatively inexpensive, underwriting may be limited, and coverage is convenient.
But group coverage can also have limitations. A typical plan may replace a percentage of base salary but impose a monthly maximum. Bonus or commission income may not be included. The definition of disability may also be more restrictive, and the coverage generally isn't portable when you leave your employer.
An individual policy can potentially fill some of those gaps. Individual policies generally offer more flexibility in benefit amounts, waiting periods, definitions of disability, and optional riders. They may also be portable, meaning the coverage stays with you rather than your employer.
Individual coverage is generally more expensive and requires underwriting, so the right answer isn't necessarily one or the other. For some people, the most appropriate solution may be using employer coverage as the foundation and an individual policy to fill important gaps.
Our Group vs. Individual Disability Insurance Comparison provides a helpful side-by-side look at issues such as benefit amounts, taxation, definitions of disability, elimination periods, portability and available riders.
How Much Coverage Do You Need?
Disability insurance generally isn't designed to replace 100% of your earnings. Insurers commonly limit individual coverage to approximately 50% to 70% of monthly pretax earnings, depending on income, health, age, and other disability benefits available to you.
But determining how much protection you need should begin with your financial life—not simply a percentage of your salary.
Consider your current after-tax income and the amount your household actually needs each month. Then think about how expenses could change during a disability. Factor in your emergency reserves, spouse or partner's income, existing employer coverage and other potential benefits.
Also consider the length of the elimination period. A longer waiting period may reduce the cost of insurance, but it means you'll need enough accessible savings to cover expenses until benefits begin.
One of the Most Important Details: What Does "Disabled" Mean?
Not all disability policies use the same definition of disability—and this is one of the areas where the fine print really matters.
An "own occupation" definition generally focuses on whether you can perform the duties of your particular occupation. An "any occupation" definition is more restrictive because benefits can depend on whether you are capable of working in another occupation.
This distinction can be especially important for people with specialized careers. An illness or injury might prevent someone from performing his or her existing profession while still leaving that person physically capable of doing some other type of work.
Policies may also provide residual or partial disability benefits when you're able to continue working but your hours, duties, or earnings are reduced. That can be particularly valuable because a disability isn't always an all-or-nothing event.
Don't Overlook the Tax Treatment
The tax treatment of disability benefits is another area that can create surprises.
Generally, if you purchase an individual disability policy and pay the premiums yourself with after-tax dollars, the disability benefits are received income-tax-free.
Employer coverage can work differently. If your employer pays the premiums, benefits attributable to those employer-paid premiums are generally taxable. Likewise, if premiums are paid through payroll using pretax dollars, the resulting benefits are generally subject to income tax.
That means a policy promising to replace 60% of your salary doesn't necessarily mean you'll have 60% available to spend. Whether the benefit is taxable should be part of your income-replacement calculation.
What About Social Security Disability?
Social Security Disability Insurance, or SSDI, can provide another layer of protection, but it shouldn't necessarily be viewed as a substitute for private disability insurance.
Social Security uses a much stricter definition of disability. Generally, your physical or mental impairment must have lasted—or be expected to last—at least 12 months or result in death, and it must prevent you from performing substantial gainful activity. You also need to satisfy Social Security's work-history requirements.
Your SSDI benefit is based on your Social Security earnings record rather than your current salary. Certain family members may also qualify for benefits based on your record.
Workers' compensation is another potential source of income, but it generally applies only when an illness or injury is work-related. Other government disability programs may apply to federal employees, veterans, military service members, or residents of states with state-sponsored disability programs.
These programs can provide valuable protection, but their eligibility requirements and benefit limitations are one reason government benefits alone may not be enough to protect your family's financial plan.
What Should You Look for When Buying a Policy?
This is where disability insurance can become complicated quickly. Two policies with similar-looking benefit amounts can provide very different protection.
Beyond the monthly benefit, you'll want to understand the elimination period, length of the benefit period, definition of disability, exclusions, pre-existing-condition provisions, monthly benefit caps and whether other disability benefits reduce what the policy will pay.
You may also encounter features or riders covering residual or partial disability, cost-of-living adjustments, future increases in coverage, waiver of premium, catastrophic disability, or return-to-work provisions. Depending on the policy, you may also want to determine whether coverage is non-cancelable and guaranteed renewable.
Rather than trying to cover every policy feature here, we've created a separate checklist of the questions worth considering when evaluating coverage: What Issues Should I Consider When Purchasing Disability Insurance?
The checklist walks through cash-flow considerations, tax issues, coverage provisions, policy features, employer coverage, self-employment considerations and how disability insurance fits into the rest of your financial plan.
Disability Planning for Business Owners and the Self-Employed
For business owners, disability planning can be particularly important because your ability to work may affect both your household income and the business itself.
In addition to individual disability income coverage, a business owner may need to consider protection for the loss of a key employee or funding for the purchase of a business partner's interest if that partner becomes disabled.
Self-employed individuals may also have fewer employer-provided benefits to fall back on. Professional associations or organizations sometimes offer group disability coverage, although those policies should be evaluated for many of the same limitations as employer plans, including benefit definitions, flexibility, premium increases and whether the coverage can be canceled.
Disability Insurance Is Part of the Bigger Picture
Disability insurance isn't necessarily the most exciting part of a financial plan. Ideally, it's coverage you'll pay for and never need. But your ability to earn an income supports almost everything else you're trying to accomplish financially—from paying the mortgage and supporting your family today to saving for retirement and other long-term goals.
At Birch Street, we don't evaluate or recommend specific disability insurance policies. Instead, we look at how the risk of losing your income fits into your overall financial picture. How dependent is your plan on your paycheck? How much do you have in emergency reserves? What benefits are already available through your employer? And what would happen to your retirement savings and other goals if your income stopped for several months—or several years?
If we identify an area that may need additional attention, we can help you understand the questions to ask as you work with an insurance professional. The goal isn't to look at disability insurance in isolation, but to make sure an unexpected illness or injury has been considered as part of the bigger picture.
