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Ask About Disability Insurance

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By | May 25, 2012

Dear Toolkit,

What's more important, life insurance or disability insurance? I can't afford them both in addition to health coverage.


Tough Choice

Dear Tough Choice,

The choice may not be so tough once you take into account the fact that a person of working age, say 21 to retirement, is far more likely to be disabled than to die by age 65. The young pups of that gainfully employed bunch are estimated to be six times more likely to be disabled than to die before age 65. Even the elders of that group are more than twice as likely to be disabled than die before they collect Social Security and head for the beach.

And the trend doesn't look good. According to the Disability Management Sourcebook, the number of folks between 17 and 44 with severe disabilities has increased 400 percent over the past 25 years. One in seven people will become disabled for five years or more before they reach 65. Looks like a pretty good case for giving disability income insurance priority over life insurance, doesn't it? (But keep in mind that life insurance is also important and may be a key issue in your particular situation. Don't exclude one or the other without consulting an insurance professional to advise you about your unique needs.)

For disability income insurance purposes, you don't need to insure 100 percent of your income; 50-70 percent of pretax income will do for most people. The bad news is that your premiums usually won't be deductible; the good news is that, if that's the case, any benefits you receive will not be taxable. And if you won't be paying taxes, 50-70 percent will give you about the same "take home" income as you had before becoming disabled.

Unlike a life insurance policy, which is designed to provide a lump sum payment in the event of death, a disability policy provides income to an individual who becomes disabled because of an accident or illness. Disability periods may be temporary or permanent, and may result from an on-the-job accident or illness, or may be totally unrelated to work. The various types of disability policies differ on how narrowly they define disability, how much periodic income they pay, how long you have to wait (the "elimination period") for payments to begin, and how long payments will go on. These are some points you should ponder:

  • When do the benefits start? Do benefits begin at the onset of disability or is there a waiting period? Common elimination periods include 30, 90 or 180 days. A lengthy waiting period gives no protection for short-term disability.
  • How is disability defined? Older policies paid full benefits for the inability to perform the exact duties performed before the disability, but no benefits if the disability permitted some gainful employment. Newer policies may grade benefits with the job function permitted by the disability. (This is an important distinction . . . the difference between your "own" profession and "any" profession. If you're a right-handed concert violinist who has three fingers cut off of your left hand in an accident, you don't want to have to take a job at McDonald's flipping burgers. You want to insure for your "own" occupation, even though you might be able to flip burgers with your right hand just fine.)
  • Is there a monetary limitation on payments? State law may impose such a limit. No matter what the owner earns or how the policy is phrased, an insurance company may not pay out more than the maximum permitted by law. For example, a business owner who earns $150,000 per year has a policy that promises to pay 80 percent of the pre-disability salary in the event of permanent and total disability. If state law sets a $100,000 limit on such payments, that is all that will be paid to the owner, even though it appears that the policy will pay $120,000 ($150,000 x 80 percent). In such instances, the owner has "overpaid" premiums, since he or she did not receive the full amount contracted for under the policy. (A good insurance agent will alert you to this possibility regarding your own state, but if you move to a new state, check with a local agent to see whether your existing policy will conflict with your new state's laws.)
  • Will multiple policies generate multiple benefits? State law may also affect whether benefits are cumulative. If they are, there's no use in carrying multiple policies. For instance, an owner has three separate disability policies, each one providing a benefit of $100,000. If state law requires that benefits be cumulative and if there is a $100,000 limit, each insurer will contribute 1/3 of the $100,000. Thus, even though the owner paid for three separate $100,000 policies, he or she actually gets the benefits as if only one of these policies was purchased.

Also, pay attention to whether a policy will pay benefits for both accidental injuries and sickness, or just one or the other. Read that small print! And another critical element is the difference between the terms noncancelable and guaranteed renewable. Guaranteed-renewable policies can't be canceled, and premiums are raised on a class, not an individual, basis. With noncancelable policies, the company guarantees fixed benefits, at a fixed premium. Go for a policy that's noncancelable to age 65 and then guaranteed renewable.

For most people, long-term disability policies are almost always the best choice, but don't overlook short-term policies, which are also very useful.

Here are sample policy statements for both long-term and short-term disability plans. These samples provide insight into many of the issues you'll have to consider, such as the amount and types of benefits to offer, the types of medical and other information that might be required, and eligibility for participation in the plan. Armed with this information, you can make intelligent choices about whether to include paid disability leaves among the benefits you provide if you have employees. You'll also be able to compare competing insurance policies more quickly, since you'll already have a feel for what you're going to see.

You'll want to be familiar with the federal and state aspects of disability coverage as, depending on where you're located, government programs can sometimes impact your tax and benefits planning.

All of these issues and more merit your attention, but they are, alas, too complex to reiterate in a short column. Therefore, in order to assure your future income stream, I recommend that you drink your milk, wear your galoshes, use your seat belt and buy as much disability insurance as you can sensibly afford, after consulting with your insurance professional to be sure you have the right risk management mix for your particular circumstances.

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