DISABILITY INSURANCE

The Health Insurance Association of America has made some startling discoveries about the need for disability insurance in this country. They estimate that a 35-year-old worker has a 12-percent chance of becoming disabled for a three-month period. By the time a worker reaches the age of 55, this chance has increased more than five times, to a 70-percent chance! Interestingly enough, these odds are the same as the odds for death. However, most people have life insurance, but no disability insurance. Why take the chance that you could perhaps become disabled and not have any protection to help you financially get through that time?

The best way to protect yourself against the adverse effects of being unable to work due to a disability is to purchase disability insurance (DI). This form of insurance will provide income to you and your family on a weekly, biweekly, or monthly basis, as long as the injury or illness is covered by the insurance. There are a few forms of DI that workers can obtain; here we cover the three main types. The first comes from the government in the form of Social Security disability benefits. The second is from a worker’s employer, and the third is DI purchased by the worker.

The need for some sort of DI is great, but, it is often overlooked. People are too concerned with insuring their lives, the lives of their children, and preparing for other types of life changes, such as a college education or retirement. Unfortunately, for most people, any missed time at work would be financially devastating. While you are off work and are using whatever savings you have, you could wind up wiping out most, if not all, of the savings you have accumulated for yourself. Many times, workers do receive some type of DI as part of their benefits from their employer, but that may not be enough.

What Is a Disability?

Disability policies will all have a specific definition for what is considered a disability. Some policies will have a very broad interpretation of the word, while others will adhere to a rather strict definition. The most liberal definition is known as the “own occupation” rule. It says that you are considered disabled if you cannot perform at least one primary duty of your own job. Under this rule, a surgeon who has lost his or her motor skills and could no longer operate would receive full benefits even though he or she could still meet with patients and consult with other surgeons and doctors. However, you can opt for a residual benefit feature, which would pay you partial benefits if you could only work for a lower salary or part-time.

Most policies use a stricter definition of disability, known as the “any occupation” interpretation. Under the any occupation definition, a person is considered disabled if he or she is unable to perform any occupation for which that person is reasonably suited or trained for. The basis for this is the individual’s education, training, or work experience. This type of policy is considerably less expensive because it gives the insurer the leeway of determining whether benefits should be paid.

Some types of individual policies include a presumptive clause, which allows the insurer to discard the any-occupation and ownoccupation rules. This clause states that the insured is presumed to be totally disabled under certain conditions, such as loss of both hands or feet, loss of eyesight in both eyes, or loss of hearing in both ears. Through this clause, the insured would receive full benefits even though they may choose to remain employed.

Social Security DI

There are two main types of social security DI benefits: cash disability income benefits, and the freezing of a disabled worker’s wage position in order to determine that person’s future retirement or survivorship benefits. A worker is considered eligible to receive benefits when he or she has a medically determined physical or mental impairment that is very severe. The impairment must be so severe that the worker must be deemed unable to engage in any substantially gainful work or employment. Any substantially gainful work amounts to what is termed an “all occupations” definition. That is, you can’t be able to do anything for pay. Nothing. Not only is that definition difficult to fulfill, the rules about it are very strict. If you become disabled and have satisfied the unable-to-work provision, you must then wait 5 months before you can collect any type of benefit. And, you must remain disabled for that entire five months if you wish to collect the benefits. After your first 5 months of waiting, the benefits begin to trickle in. However, to continue collecting, your disability must be expected to last at least 12 months from when the impairment started, expected to result in death, or have already lasted 12 months. It’s also important to note that the Social Security Administration rejects approximately 40 percent of all disability claims it receives.

The social security program uses your current wage subject to social security taxes to determine what your benefits would be. These benefits are paid to the disabled worker and that person’s dependents. Regardless of whatever private insurance a disabled worker has, he or she will receive social security benefits. Let’s assume that Joe Client is 35 years old. His wife, Mary is also 35, and they have two children, Tommy (age 5) and Lindsey (age 2). Joe makes $40,000 per year and becomes seriously injured in a train accident. Joe remains impaired for the five-month waiting period and begins to collect his benefits. For this illustration, we’ll assume Joe’s benefits are $1249 per month.

Joe’s monthly benefit _ $1249—until recovery, death, or
age 65

Mary’s monthly benefit _ $972—until Lindsey reaches 16 (14 years)

Tommy’s monthly benefit _ $972—until he is 18 years old (13 years)

Lindsey’s monthly benefit _ $972—until she is 18 years old
(16 years)

However, there is a maximum family benefit, so in Joe’s case, he and his family would only receive about $2289 per month ($27,468 per year). As long as Joe remains disabled, his family will continue to receive $2289 per month for the next 16 years (at that point, Mary, Tommy, and Lindsey would no longer be eligible). They would then receive $1249 per month for 14 years, or until Joe is 65 years old. Once Joe turns 65, his social security benefits would begin.

Even though these benefits are coming from the government, that doesn’t mean that they are guaranteed to be tax-free. They may be tax-free, but they may not be. For the preceding example, it’s likely that Joe’s benefits would be tax-free. But assuming that he did have to pay federal income tax, and if Joe falls in the 15-percent tax bracket, the nontaxable (gross) equivalent of his social security benefits would be $2693 per month ($32,316 per year). That falls quite short of his $40,000-per-year gross salary.

How does that sound as a sole form of benefits? Most people I know don’t want to wait five months to collect benefits, nor do they wish to tap into their savings to help cover those five months. The benefits don’t begin to cover what a worker would normally bring home in pay, plus they may also be taxable. Relying on Social Security benefits in the case of a disability is not a financially responsible, or wise, decision.

DI as Part of a Worker’s Benefits

As part of an employee’s benefits package, many employers will include some sort of disability insurance, which is paid for entirely by the employer. This is not only a benefit for the employee, but, if used, will also cause the employee to face some tax consequences that may not have been considered. Employer-sponsored DI plans are a benefit for the employer, as well, because they provide the employer with another tax deduction. An employee may receive short-term DI, long-term DI, or both from his or her employer.

The biggest benefit to an employer-sponsored DI plan is that employees don’t have to pay for their own insurance. Plus, the amount that the employer pays for the insurance is not included in the employee’s gross income. So, not only does the employee not have to pay for the coverage, but he or she is also not taxed on the premium amount. Of course, if the coverage is used, this may come back to haunt the employee. However, if the coverage isn’t used, then the DI still remains a benefit, since the employee hasn’t paid out any money. Employers are able to take out a group policy for all eligible employees, so, their premium amount is much smaller than if all the employees were to take out separate policies on themselves. This also makes entry into the plan much easier for the employee. Simply by filling out the applicable forms and waiting the required amount of time (usually employers mandate that an employee wait three months before being allowed to participate in any type of benefits program), the employee has disability coverage with no out-of-pocket cost. The coverage will then remain in effect for as long as the employee remains eligible.

Typically, DI plans are split into two categories: short-term and long-term. Short-term benefits usually have a schedule of weekly benefits that are based on earnings categories. However, they have relatively low maximum benefits. That is, the overall payout is rather small when compared with long-term plans because short-term plans only cover a specific amount of time, such as 6, 12, 26, or 52 weeks. These plans are designed to cover a moderate amount of earnings over a short period of time.

Long-term plans typically kick in after a short-term plan has expired, so that there are no overlapping benefits. This type of coverage takes care of more serious, long-term illnesses and disabilities. Long-term coverage is specified by a percentage of earnings, such as 70 percent, and is accompanied by a higher base amount of benefits, which could provide the recipient with monthly benefits of $5000 or more. Generally, the elimination period for long-term DI is longer than it is for short-term since the recipient is generally receiving short-term DI benefits during that time.

A very important consideration about employer-sponsored DI is that the employer pays for it, not the employee. And, since the premiums paid aren’t included in the employee’s gross income, any benefits received under the plan may be taxable to the employee. Generally, the tax code provides that money received through accident or health insurance due to personal injuries or illness be excluded from the individual’s gross income for tax purposes. This rule, though, excludes any benefits received from an employer-sponsored plan where the contributions were made by the employer and not included as part of the employee’s gross income. Thus, if you receive $627 per month in disability benefits from your employer’s DI plan and you didn’t contribute any money toward the cost of the insurance, that $627 would be considered your gross income and you would be liable for taxes on it.

An employee’s coverage may be terminated, also. This would occur when the employee quits or retires. The employer may also decide to terminate the coverage, which would result in all covered employees no longer having the insurance. Or, if the employer fails to pay the premium (unless there is an error), the coverage will be canceled. If the employee quits, he or she doesn’t have this option to extend the benefits, or roll them over into an individual plan. That person will then have to wait to fulfill his or her new employer’s elimination period before having coverage again.

Because employer-sponsored DI coverage is designed for workrelated accidents, it shouldn’t be taken into account when considering financial planning. Relying on this type of DI to cover you is like planning to die in a car accident. You don’t know that you will become disabled on the job, just like you don’t know how you will die. Should you become disabled at work, this insurance will help cover your expenses, but, if you aren’t hurt at work, then it will be of little use to you.

Individual DI Plans

The best way to make sure that you are covered in the case of a disability or debilitating illness is to purchase your own DI insurance. Although there is a growing importance placed upon group forms of coverage, there are also a number of reasons why an individual would need his or her own coverage. First, the amount of coverage provided by the group plan is insufficient. Second, the duration of benefits may not be long enough. Plus, many people simply do not want to rely on a group plan, especially if the benefits will wind up being taxable to them. Benefits paid under an individual plan would normally be tax-free.

Just like with other forms of DI, there are elimination periods with individual plans. But because you are paying for your own coverage, you may be able to choose the length of your elimination period. Again, the premium amount is tied to the length of the elimination period. While cost is a factor, don’t let it be the overriding aspect to picking out your policy. It’s more important to be sure that you are fully covered in the case that you need it, rather than saving a few bucks in the immediate future.

Individual policies may cover illness in addition to accident (known as accident and sickness coverage), as opposed to just disabilities resulting from an accident (accident-only coverage). It’s important to insure yourself against illness, as well as accidents. If you are unable to work due to an illness and receive benefits from your coverage, you’ll find that those will help even if your medical bills are totally covered by your health insurance. Plus, your medical bills may not be covered by your health insurance.

With today’s individual DI policies, you can choose from a wide array of coverage periods. You could opt for a short-term type of policy, with coverage ranging from six weeks to a few months. Or, you could choose a policy that would cover you for the rest of your life. Whatever period you select should be based upon your needs, not someone else’s desire to sell you a bigger policy.

As far as individuals are concerned, the own occupation is the better of the two disability definitions. When coupled with the longer coverage period, this is the best option for the insured. However, since the coverage is better, the premium will be more expensive. Do your homework and compare the different premium amounts and coverage options from many different insurance companies to find the policy that best suits your needs. Don’t be swayed by cost alone.

Do you need disability insurance?

Ask yourself these two questions:

1) Is your salary the main source of income for your family? 2) How would you replace your income if you were unable to work?

If you can answer these questions to your satisfaction (or if you already have some form of DI), then you don’t need to worry about thinking about this. However, if you don’t like your answers, or if you are unable to answer the second question, it’s time to think about some type of disability insurance. Remaining unprotected is one of the surest ways to not reach your goals, and perhaps devastate you and your family financially.

Determining Your Need

The point of disability insurance is to replace all or most of your income should something happen that would render you unable to earn a living. Since most plans would allow you to receive your benefits tax-free, you really only need to concern yourself with replacing your net income (what you bring home after taxes). By looking at what benefits you currently have available to you, you can estimate what your need is and how much coverage you should purchase in an individual plan.

The first thing you should do is look at last year’s tax return. Take your gross income and subtract all taxes paid, including social security tax. Don’t include any income you receive from dividends or from outside sources, just refer to your job income. Then divide this total by 12 to calculate your monthly net income.

Then, estimate your social security benefits. Not all people are eligible, so don’t be surprised if you find out that you won’t be able to receive them. If you are eligible, you can receive an estimate of your benefits on the social security Web site (see previous footnote), or by calling your local social security office. It’s important not to rely on this, so although you can use these figures to help estimate your need, please keep in mind that 40 percent of all claims are denied. The likelihood of receiving benefits is very small, and it takes five months to begin receiving them. There are other types of benefits that you may be eligible for through both the government and other types of group policies. I’m not going into these here, but just be aware that social security and employer-sponsored plans aren’t the only types of DI that you may have as an option.

If you are eligible for any employer disability benefits, you can contact your employer to see what type of benefits you would receive. A good idea is first to ask your employer about any sick leave or wage continuation programs they may have because these would act as a form of short-term coverage. Whatever you wish to include, be sure you are aware of what the tax ramifications would be.

Add up any monthly benefits you are counting on receiving and subtract that number from your net income. This resulting number is the amount of money you would still need to help cover your bills and replace your income. (See Figure 12.1 for a sample worksheet.) Of course, any type of investment income (i.e., dividends or interest) and spousal income (if your spouse works) would still continue, and so, are ignored as part of the beginning gross income amount.

There are some provisions to consider when purchasing DI. First, many policies offer a cost-of-living adjustment (COLA), to help protect you against inflation. If you purchase a policy that will pay you a flat benefit of $3000 per month now, that $3000 won’t have the same purchasing power in five years. With a COLA, the benefit is annually adjusted for inflation, is usually in line with the Consumer Price Index and takes effect once the insured is disabled. However, your insurance company may cap its rate to avoid for super-high adjustments.

Many insurers will also offer a waiver of premium option. For those insurers that offer it, it will be automatically included in your policy. This provision is especially beneficial because it says that once you are disabled for a period of time (normally 60 or 90 days), all your future premiums will be waived for the duration of your disability. This also acts somewhat as an increase in your benefit because you will retain the premium amount in your pocket, rather than paying it out to the insurance company.

Then there is the guaranteed insurability option that allows you to purchase additional disability income insurance while you are still healthy. With this provision, you don’t have to prove insurability again, which is nice.