Insurance Basics: How Disability Insurance is underutilized but Critical

Contributed by: Nick Defenthaler, CFP® Nick Defenthaler

As we continue through our insurance basics blog series, we move on to discuss disability insurance.  According to the Social Security Administration, studies have shown that just over 25% of today’s 20 year-olds will become disabled at some point before reaching age 67. Wow! This is a pretty staggering statistic –these odds are far greater than a pre-mature death, which is what life insurance is typically purchased to protect against (see my last Insurance Basics blog on Life Insurance). However, often times when we discuss disability insurance with clients, we find that it’s an area of confusion. Many aren’t even sure if they have coverage or they may believe that Social Security will kick in and be enough. For most of us, especially if you’re in the early stages of the “accumulation mode” of your career, your earnings power, or human capital, is most likely your largest asset both now and into the foreseeable future. A disability can wreak havoc on this “asset” which is essentially why disability insurance is purchased. Let’s look at the basic types of coverage:

Short-term vs. Long-term Disability

Long-term disability typically has what’s known as an “elimination period” of how many days must pass before benefits begin. This is often called the “time deductible” of the policy which in many cases is 90-120 days. Benefits can pay out up until age 65, however, most policies have a stated period of time where benefits would be payable. To help bridge this gap of coverage, a short-term disability policy can come in handy because benefits will usually begin within a week or two of disability and continue for up to one year, although benefits typically last between three to six months. Short-term disability policies can be a great backstop to preserve your emergency cash fund, typically at a fairly reasonable cost. 

Group Coverage

As with life insurance, many employers offer a form of disability insurance to their employees as part of their benefit package. Sometimes the employer will pay for the premium in full and other times the employee will have the option to pay for premiums (fully or partially). You may be asking yourself, “Why would an employee want to pay for the group coverage instead of having the employer foot the bill?”  Great question, with very important ramifications! If the employer pays your premiums in full, the entire amount of your benefit if needed (typically between 50% and 60% of your pay up to certain limits) would be taxable. If you as the employee were paying for the premiums in full and you needed the coverage, benefits paid out would NOT be taxable. If you were only paying a portion of the total premium, say 20%, only 20% of the benefits paid would be non-taxable to you as the employee. The tax treatment of benefits will have a large impact on the net amount of benefit that actually hits your bank account so it’s important to understand who’s paying for what if you have access to a group disability policy at work.

Individual Coverage

As the name implies, individual coverage is purchased by you through an insurance company – the policy is not offered through your employer. A major benefit of purchasing an individual policy is that the coverage is portable. You can take it with you if you change jobs because it’s not tied to your company’s benefit package (most group policies are non-portable). Another advantage (or disadvantage depending on how you look at it), you are paying for the coverage so if benefits are needed, they will not be taxable to you. With an individual policy, you have control over selecting the definition of disability that your policy uses (any occupation, own occupation, etc.) and you’d also have the option to add any additional features to the policy (for an additional cost), known as “riders.”

As you can probably tell, we’re just scratching the surface on disability coverage. As I mentioned, it is often times the most over looked part of a client’s financial plan and coverage types, despite its high probability and significant risk of long-term financial loss.  At minimum, check with your employer to see if group coverage is offered (both long-term and short-term) and consult with your financial planner on whether or not it is sufficient or if additional coverage would be recommended. If you have questions about your current coverage or how you think disability insurance should fit into your financial plan, give us a call!

Nick Defenthaler, CFP® is a CERTIFIED FINANCIAL PLANNER™ at Center for Financial Planning, Inc. Nick is a member of The Center’s financial planning department and also works closely with Center clients. In addition, Nick is a frequent contributor to the firm’s blogs.


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