Should I consider disability insurance? What if I already have an employer-sponsored plan? Is my existing coverage sufficient? These are important questions and I hope to provide some answers here.
Statistically speaking these questions should be considered by many more Americans because we are over three times more likely to lose some or all our income during our working years due to a disabling sickness or injury than premature death. Think about that for a second and ask yourself why most people buy life insurance. It is to protect your family’s financial wellbeing should their income be lost due to your death, yet most Americans stop there and don’t consider the much more probable risk of disability.
And let’s not forget that disability also contributes a burden on family and friends of caring for a disabled loved one. A spouse, parent, sibling, child, or close friend would likely have to surrender some or all of their livelihood to care for a disabled individual, be it for a period of months or perhaps many years.
I have spoken about human capital potential in earlier articles when discussing life insurance. This is the insurable loss we are protecting against. Let’s take an individual making $100,000/year who suffers a disabling injury at age 40 for example. Let’s determine retirement to be age 65 with a $5,000 annual employer health insurance subsidy, 6% retirement fund match and annual employee contribution of $6,000. If we use 3% income only inflation and 6% growth on retirement funds that would be a human capital potential of $4,304,290. Adjusting for an average tax rate of 30% would be $3,058,003 with the tax-free employer-paid health subsidy. This would not take into account higher medical costs or additional income lost by close family and friends as a result of caring for a disabled individual held dear to them.
Depending on your employer you might already have an employer-sponsored Long Term Disability Plan. These plans are more common in some industries than others and are also largely dependent on the size of the employer. They provide an invaluable and often underappreciated benefit to employees covered by them. That said how does the benefit work and is it sufficient for you? The answer is it depends on your income.
Most disability plans pay a 60% pre-disability benefit but most people don’t realize that partial benefit is then taxable as earned income. This means if you make $100,000/year, your LTD benefit would be $60,000 before taxes. It is impossible to account for individual deductions and graduated tax rates here but assuming a 25% total rate pre-disability and a 20% total rate post disability that is a $33,000 /year gap in coverage in the first year alone when we account for the loss of employer match and health insurance. Would this work for you and your family also considering the potential added expenses of the disability itself?
Then there is the question of social security disability. Even if you qualify for social security disability payments your group LTD plan will simply offset these payments. As an example, if you qualify for $5000/month LTD but will also receive $2,500/month SS, then the LTD would only pay $2,500/month and both benefit amounts would be taxable as income at that point.
Here’s the reality: If you make more than $75,000 per year you should strongly consider supplemental disability coverage especially if you believe or expect your income to go up in future years. The insurable gap exponentially increases with incomes over $70,000. Someone making $280,000/year has a gap of over $80,000 in year one alone. A supplemental plan here would provide well over an additional $2,000,000 in coverage over 25 years at a cost of around $200/month. If you qualify for supplemental disability the biggest thing to consider is future insurability. Maybe you only qualify for $1,000/month additional coverage this year but as your income and the coverage, gap grows you can increase your coverage with no further underwriting. Disability insurance is typically fully underwritten and the current and future premium rate, even as the benefit might increase is based on the age and health rating at initial policy issue. This is huge! It means buy coverage as early as you can to ensure the ability to buy coverage and at a much lower cost in the future than if you wait.
Let's summarize a few key differences between a group long-term disability policy and an individual disability or supplemental disability policy. An employer-paid long-term disability policy is owned, paid for, and deducted as an expense by the employer on behalf of the employee. This means the benefit is almost always taxable to the employee if disabled. The group LTD policy can be terminated or changed by the employer without consent by the employee. If the employee terminates employment they may or may not have the ability to convert the policy to an individual policy with certain limitations. The contractual definition of disability and benefit payments also have some limits typically not found in individual plan contracts which often contain much stronger more liberal definitions of disability and benefit payments than group plans.
On the other hand, an individual contract is owned and paid for by the insured in most cases, and premiums are paid with after-tax dollars meaning that benefit payments are tax-free. Individual disability plans are often non-cancellable which means the contract cannot be canceled or premiums increased at any time during the benefit period and can also be structured to replace a much higher percentage of pre-disability after-tax income, especially considering most plans DO NOT offset social security payments. As I’ve said before, no one insures their house for half of its value so why would you insure your most expensive asset, your future income for a fraction of what it's worth?
Finally, perhaps it is obvious, but not all disability plans whether employer-sponsored group plans or individual plans are created equal. There are wide differences in contract language for the basic definition of disability as well as a host of riders that determine occupational definitions, partial disability, residual disability, catastrophic disability, and mental nervous disorders. It is very important to know which disability contract you are buying and if it specifically helps your own situation. As always, this is why it is essential to consult with a professional who specializes in disability and represents several carriers in order to guarantee the right product is chosen at the most competitive cost for your individual needs.
The information contained in this article is general and is provided for educational purposes only. It is not intended to provide legal or tax advice. You should not act on this information without consulting your own legal counsel and/or other knowledgeable advisors.
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