When you think of insurance coverage, the two most common types - home and car insurance - are often the first that spring to mind. Because the mortgage company requires the former, and the law requires the latter, you don't have much of a choice when it comes to deciding whether to be insured. However, it's your ability to earn an income that allows you to afford these items. In fact, without earning potential, it would be difficult for many of us to maintain our homes and automobiles while still providing for our families. The solution for supplementing this missing income in the event of a permanent or temporary disability is known as disability insurance. Here we explain why disability insurance should be an integral part of your financial plan and what you'll need to consider when choosing a policy to protect your income.
TUTORIAL: Introduction To Insurance
Social Security and Disability
Many U.S. workers take disability risk management for granted because they assume that the Social Security system will take care of everything should they become disabled. Contrary to popular belief, qualifying for Social Security disability benefits can be quite difficult, and it often takes a long time for the benefits to start. To qualify, you must prove that you are incapable of performing any job, not just your primary occupation. As long as you can be gainfully employed, even if it's working for minimum wage, you won't be able to collect Social Security disability payments.
The Social Security Administration (SSA) will consider a person to be "disabled" if all of the following requirements are met:
- He or she lacks the ability to engage in any substantial gainful activity (SGA).
- The incapacity is due to one or more medically determinable physical or mental impairments.
- The incapacity has lasted or can be expected to last for a continuous period of at least 12 months or to result in death.
In order to meet the requirements for disability coverage under Social Security, applicants must pass a "recent work" test based on their age at the time they became disabled. Passive income activity, such as investments and sick pay would not be considered gainful activity income. However, if you claim disability, are younger than full retirement age and are earning income of more than $1000 a month (in 2011) and are not blind, this could lead to a declined claim because it would be considered substantial gainful activity. Even if you are eligible for benefits, it's highly unlikely that the benefit will meet your financial obligations - the payment for an individual who earned over $95,000 per year before becoming disabled is only $2,224 per month as of 2010.
Protecting Your Family and Income
When reviewing your risk management objectives, you need to take a close look at your emergency reserves and liquidity capabilities. (To learn more, see Build Yourself An Emergency Fund.) If you became disabled and qualified for a maximum SSA monthly payment for your age and income, would this be enough income to support your budget? According to the U.S. Census Bureau, the average median monthly household income was $4,200 in 2010. This data strongly suggests that a supplemental income source would be a necessity for many Americans if they were to become disabled. It's important that you understand the benefits provided by your company, as you may be covered under a short-term or long-term disability policy through your employer benefits plan. When it comes to disability insurance, "short-term" refers to periods of 90 days or less, while "long-term" refers to periods of more than 90 days.
Once you've determined what disability risk management you have in place, you can then make an educated decision as to whether you are fully insured or underinsured. If you lack the appropriate income replacement, you may want to consider buying a personal disability policy. As with most types of insurance, the older you get, the more expensive the coverage will become. Therefore, you may want to acquire a policy now while you are illness and accident free. Whether your benefits are taxable will typically depend on how the premium is paid. In most cases, if you pay the premiums with after-tax dollars, the benefit received will be tax free. However, if your employer pays the policy premiums for you, then the benefit will likely be treated as taxable income when paid to you. (For further reading, see Insight Into Insurance Scoring.)
Here are some questions to consider when looking into disability insurance:
How much coverage should you consider?
You should consider obtaining enough coverage to maintain your family's current standard of living. While gauging your required amount of replacement income, it is best to err on the side of conservatism. However, recognize that you may save on certain living expenses (such as driving to and from work every day) that may reduce the amount of replacement income you will need to maintain your family's lifestyle. In short, be sure to consider both sides of the coin when assessing your coverage needs.
What is an "elimination period"?
The elimination period is the amount of time that you must wait before your benefits kick in. The typical elimination or waiting period for most policies is 90 days, which means you must have your own resources for the first 90 days of your disability. Be sure to incorporate your insurance plan's elimination period into your personal saving requirements.
For how long will an individual policy pay a benefit?
Since there are many different options for this, you can select the period of time for which your benefit will last. The best policy would entail benefits being paid until you reach age 65, at which time retirement benefits should become accessible to you.
What is the difference between "own" and "any" occupation?
If you're looking at policies that allow you to select between "own occupation" or "any occupation," you'll want to consider a plan that defines "disabled" as unable to continue work in your current profession - known as "own occupation." Otherwise, if you choose "any occupation," you'll need to be unable to perform any type of work in order for the policy to pay any benefits.
The Bottom Line
The overall decline in the number of insurance companies writing disability insurance in the past 20 years has resulted in the cost and frequency of disabilities among workers to increase. What would happen to your household income if you became disabled for a long time? Hopefully, you and your family would be taken care of, but if you're not sure that's the case, now might be the time to cover that risk. After all, part of being a savvy investor is making sure that your family is not unduly burdened by risks you can't afford to take.