If you’re like many workers today, you may be wondering, “Do I need disability insurance?” If you don’t have a lot of money saved up or have dependents or other loved ones who depend on your earned income to survive, then the answer is yes. Disability insurance can replace some or all of your earned income if you become injured or ill for a period of time, such as one year. While health insurance can cover your actual medical expenses, disability insurance will cover your other bills, such as your rent or mortgage payment, car payment and utilities.
- Who Needs Disability Insurance?
- Death vs. Disability
- Causes of Disability
- Possible Scenarios
- How Disability Insurance Works
- Elimination Period
- Benefit Period and Amount
- Own-Occupation vs. Any-Occupation
- Tax Treatment
- Partial vs. Total Disability
- Factors to Consider
- Pros & Cons
Who Needs Disability Insurance?
The income that you earn is probably your most valuable financial asset, especially if you are young and have small children. Anyone who will not be able to pay their bills if they become disabled should carry at least some form of this protection.
And while most people wouldn’t think of going without life or health insurance if they can possibly afford it, disability insurance is frequently overlooked. And the odds of your becoming disabled are far higher than the chance that you will die prematurely.
Web MD estimates that the odds of someone becoming disabled for a period of time before they retire is about 1 in 3 – a much higher percentage than you would probably think. And the Social Security Administration estimates that one in four 20 year-old Americans will become disabled for some period before they retire.
Becoming disabled without insurance to protect you is easily one of the worst-case scenarios that you could face.
Death vs. Disability
Disability can also be far more devastating financially than death. If you die prematurely, then you may have some medical bills, but your life insurance can cover that and other expenses such as your funeral. The expenses will stop at that point.
But if you become disabled for a long period of time, then someone may have to care for you either at home or in a nursing care facility, which is very expensive. And health insurance will not cover this type of expense in most cases, which means that you’ll have to foot the bill yourself. This will most likely be impossible without disability coverage.
Causes of Disability
Illness is by far the most common cause of disability claims. Injuries come in a distant second. Some of the most common causes of disabilities include:
- Back Pain
- Heart Disease
Let’s assume that you are 30 years old with a spouse and two children at home for whom you are the sole source of support. You begin feeling ill and are diagnosed with cancer.
The doctors say that it will be at least five years before you can go back to work, and that you will need to undergo a rigorous rehabilitation program in order to be able to function normally again. Your health insurance may be able to cover the rehabilitation cost, but how will you pay your rent or mortgage, car payments and utilities?
Your spouse may be able to find some work to help with this, but if you were the sole breadwinner then you will be faced with bills that must be paid immediately. And your spouse may not be able to find work right away, and may not be able to earn as much as you did. This is where disability benefits comes into play.
If you have this form of protection, it will start paying you a monthly benefit after a certain point. And don’t count on Social Security disability insurance to cover you if you become disabled; over half of all claims are rejected upon first examination.
How Disability Insurance Works
Disability insurance comes in two basic forms. Short-term disability lasts anywhere from 90 days to two years in most cases, while long-term disability usually kicks in after a year or two and then pays a monthly benefit. Most people who carry disability insurance get it through their employers with a group discount.
Short-term disability can in fact only usually be carried on an affordable basis through a group plan. Disability insurance differs from workers’ compensation in that you don’t have to become sick or injured while on the job in order to collect benefits.
Disability insurance policies never start paying immediately when you become disabled. A waiting period, known as the elimination period must be satisfied before the policy will begin paying benefits. For a short-term disability policy, this could be as soon as two weeks or as long as 90 days.
Long-term policies generally don’t start paying out benefits until a year or two has elapsed. But look closely at the cost of short-term disability coverage; it may not be worth it in many cases, especially if you have a solid emergency fund.
Benefit Period and Amount
The benefit period is the amount of time that the policy will pay out its benefits. As mentioned previously, short-term disability insurance can pay out for anywhere from 90 days to two years once the elimination period has been satisfied. Long-term disability insurance can pay out benefits for three, five or ten years, or even until retirement with the best policies.
The benefit amount is the dollar amount that the policy pays each month. Most disability policies will replace 60 to 70 percent of your money on a monthly basis. They never pay 100% of your earned income, because it could incentivize you to simply remain disabled and continue to receive benefits at the expense of the insurance company.
Own-Occupation vs. Any-Occupation
Disability insurance can be further divided into another set of categories. Own-occupation disability insurance will pay you a benefit if you become unable to perform the duties in your chosen profession. This type of coverage is more expensive but will pay you a higher benefit.
Any-occupation disability coverage will only pay you a benefit if you become unable to work any sort of job. This coverage is cheaper, but it is much harder to qualify for benefits, and the benefit is usually less than for own-occupation coverage.
There are three types of own-occupation coverage available in the marketplace today, broken down as follows:
- “True” Own-Occupation Disability Insurance – This is the purest form of own-occupation coverage. This coverage will pay you a monthly benefit even if you become able to work another job somewhere else. But be sure to find out from your insurer what their definition is for your profession; some insurers consider your whole professional specialty, such as law enforcement or accounting to be your occupation.
- “Transitional” Own-Occupation Disability Insurance – This type of policy will adjust your benefit accordingly if you are still able to work another job. Say for example, you were earning $6,000 a month before you became disabled, and your disability policy will pay you $4,000 a month. If you get another job paying $3,000 per month, then the policy would only pay you $1,000 a month to make up for the difference.
- Own-Occupation, “Not Engaged” Disability Insurance – This form of coverage is also referred to as “modified” own-occupation insurance. It will not pay out any benefits if you start working at another job. If you can work another job but don’t, then it will pay out. This is the strictest form of own-occupation disability insurance coverage. The only difference between this form of coverage and any-occupation coverage is that the latter form of insurance won’t pay you a benefit if you are able to work any type of job, regardless of whether you actually do or not.
- There are also hybrid policies that will initially pay out an own-occupation benefit that will allow you to work another job and still receive benefits. Then it will convert to any-occupation coverage after a certain period of time, such as two years.
The tax rules for disability insurance are fairly simple. If you paid for the cost of premiums out of your own pocket and didn’t deduct them on your income tax return, then the benefit amount is tax-free to you. If you did deduct the cost of the premiums on your taxes, or your employer paid your premiums using pretax dollars, then the benefit amount will be taxed as ordinary income.
This means that you’ll pay tax on this money at your top marginal tax rate. The tax treatment is another reason why most policies will only pay you a percentage of your earned income, because it may roughly equal what you were taking home after taxes while you were working.
Partial vs. Total Disability
Disability insurance will pay out if you become either partially or totally disabled. If you become partially disabled, then the policy will calculate a residual benefit that it will pay you for the duration of your disability.
- For example, if you become crippled from a car accident but are still able to get around and go to work, then your policy might pay you a monthly benefit equal to 30% of what you would receive if you were totally disabled. And, of course, if you become totally disabled, then the policy will pay out the maximum monthly benefit to you.
Most disability insurance policies come with a list of exclusions for which they will not provide coverage. Skydiving and mountain climbing are examples of two activities that most disability policies will exclude in the terms of their coverage. Preexisting health conditions such as cancer or diabetes may likewise be excluded, and most insureds have to pass a medical exam in order to get approval for coverage.
Factors to Consider When Buying Disability Insurance
There are several things that you need to consider when shopping for disability insurance. The cheapest place to get coverage will probably be a group policy through your employer if they offer this benefit. Standalone individual policies are usually more expensive.
However, if you are a high-income earner, then you may want to consider purchasing a standalone policy so that you will always be covered regardless of who you work for. Also consider how long you would like the elimination and benefit periods to last.
If you have a family history of medical problems such as cancer or heart disease, then you may want long-term disability coverage that lasts a good long time, such as until retirement. You can also choose a policy with a higher elimination period in order to reduce the cost of the premiums.
The longer the elimination period, the cheaper the policy. This is an especially good idea if you have an emergency fund saved to cover a couple of years’ worth of expenses. And if you have to choose between short and long-term coverage but can’t afford both, you should probably go with the long-term coverage in most cases, as this would cover you for a much longer period of time.
The benefit amount is another important factor to consider. In most cases, you’ll want to replace at least 60% of your pretax income that you earn from your occupation so that your take-home pay will remain about the same. Just be sure that you pay the premiums with after-tax dollars if at all possible so that your benefit will be tax-free.
Also be sure to look for policies that are custom-tailored to your profession. Many insurance brokers offer policies that are specifically geared for doctors, lawyers, accountants, law enforcement and other occupations, so you may get more bang for your buck with one of these. And don’t forget additional riders that you can purchase, such as a COLA rider to keep pace with inflation or a return-of-premium rider.
Pros and Cons of Disability Insurance
The obvious advantage provided by disability insurance is that it can replace your income if you become unable to work. The obvious disadvantage is the cost of the monthly premiums. An own-occupation policy that replaces 70% of your earned income can easily cost you 3% of your gross income for the year.
Most disability policies cost anywhere from $500 to $2,500 per year. And if you want to receive a tax-free benefit, this amount is not deductible.
If you don’t have a substantial amount of money in savings and have family or others who depend on your income, then you need disability insurance. Consult your financial advisor or life insurance agent for more information on this type of coverage and which policy is right for you.