Disability insurance protects a portion of your income in the event of losing your ability to earn a living, due to injury or illness. If you or your family depend on your income, assessing disability insurance coverage is a must.
What is disability insurance?
Disability insurance, sometimes called disability income insurance, replaces a portion of your income if you become unable to work due to injury or illness. If you or others depend on your income, you should likely carry disability insurance.
Disability insurance covers far more than physical injuries. Common disability insurance claims include musculoskeletal injuries (degenerated disks, back pain), nervous system-related disorders (Alzheimer's, Parkinson's, MS), heart attacks, cancer, and mental health issues.
The social security administration estimates that 1 in 4 of today's 20-year-olds will become disabled before they reach age 67.
Types of Disability Insurance
There are two primary types of disability insurance: short-term and long-term.
In general, long-term disability policies are appropriate for most workers, while short-term policies are unnecessary if you have an adequate emergency fund. The following graphic summarizes the common features of both types.
Short-term coverage will only provide benefits for a short period (typically 3-6 months). While long-term coverage will often provide benefits for at least five years, and perhaps even until retirement age. (Long-term disability policies will often only provide coverage through full retirement age, at which point you will be eligible for social security benefits.)
The benefit amount for short-term policies tends to be higher than long-term policies. Short-term disability policies will typically cover 70% of your income, while long-term policies typically cover 40%-70% of your income.
Despite radically different benefit periods (up to 6 months vs. 5+ years), the cost of short- and long-term disability insurance tends to be similar: about 1%-3% of your income. So short-term disability policies are relatively expensive and can be forgone if you have an emergency fund to bridge the gap between a disability and when your long-term disability policy kicks in.
The elimination periods (or the amount of time you need to wait between becoming disabled and receiving benefits) vary dramatically. Short-term policies typically have 2-week elimination periods, while long-term policies will often have 3-6 month elimination periods.
How much disability insurance do I need?
1. Estimate Basic Living Expenses
The first step in determining your disability insurance need is to review your budget to calculate basic living expenses for yourself and your family. If you were to become disabled, your lifestyle would inevitably change, but certain expenses would remain.
Adjust your current budget to estimate your expenses in the event of disability: keep housing and food costs, but perhaps cut back on travel or other discretionary spending. This adjusted amount is a good starting point for determining an appropriate coverage amount.
2. Review Current Coverage Amounts (often provided by employer)
Next, review any existing disability coverage. Disability insurance is a common employer-provided benefit, so review your employee handbook to determine any short- and/or long-term coverage provided by your employer.
Compare your existing coverage to your estimated expenses calculated in the first step and be sure to take taxes into consideration. If your employer provides disability insurance coverage or if you pay your insurance premiums with pre-tax contributions, any benefits paid would be taxable to you.
For example, assume your employer provides long-term disability coverage of $6,000 per month ($72,000/year). If you were to become disabled, this benefit would be taxable. Assuming this is your only income for you and your spouse, the $6,000 monthly benefit could be closer to $4,864 ($58,362/12) after-tax.
And after-tax is the only thing that matters.
If you pay for your insurance premiums with after-tax dollars, any benefits paid from the policy would be tax-free.
3. Assess Potential Coverage Gaps
If your employer does not provide disability insurance coverage or if your coverage is inadequate, determine your coverage gap for short-term or long-term disability insurance, or both.
Disability insurance is not necessary if you have the assets to cover your living expenses. While amassing the assets to cover a long-term disability is challenging (or impossible) early in your career, with an adequate emergency fund you can forego short-term disability insurance.
Short-term disability insurance will typically only cover the first 3-6 months of a disability, and it will cost 1%-3% of your income for this relatively short coverage period. If you have enough saved in your emergency fund to cover 6 months of basic living expenses, then you likely don't need short-term disability insurance.
Key Features and Options of Disability Insurance
As you consider disability insurance and perhaps even apply for a policy, the following definitions and options may come into play.
Elimination (or Waiting) Period
The elimination period is the amount of time between becoming disabled and when you will begin receiving benefits. The longer the elimination period, the cheaper your premiums.
If you have an emergency fund to cover your expenses for several months, you can opt for a longer elimination period.
The benefit period is the amount of time you will receive benefits.
For short-term policies, the benefit period is typically 3-6 months. For long-term policies, most coverage will last at least 2 years, but you may choose longer periods (typically in five-year increments), or until you reach retirement age.
Own-Occupation vs. Any-Occupation Coverage
Own-occupation disability insurance provides benefits if you are unable to perform your current job, even if you could perform other jobs. Any-occupation disability insurance only provides benefits if you are unable to perform any job.
Own-occupation coverage will clearly be more expensive but correspondingly more valuable, especially to specialized workers.
Residual Disability Coverage
Residual disability coverage provides benefits if you become partially disabled and lose some income as a result.
Electing "non-cancelable" coverage essentially means just that: your policy, premiums, and benefits cannot be canceled by your insurer (so long as you pay your premiums). Also, even if your income were to drop in the future, in the event of a disability the insurer would pay the originally agreed-upon benefit per the policy.
Without this feature, your premiums may change over time or your insurer may drop coverage if they deem your risk has increased.
Where to get disability insurance?
Check with Your Employer
Your employer is a great place to start reviewing your disability insurance options. Although you may not be able to change the amount of your coverage, you may be able to change how premiums are paid.
As mentioned previously, if your employer is paying your disability insurance premiums or if you are paying premiums with pre-tax deductions, then benefits would be taxable. You may be able to ask your employer to change the payment structure so that you are paying premiums after-tax. Then, if you were to become disabled, your benefits would be tax-free.
Review Online Options
Online insurance providers (like PolicyGenius or Breeze) offer a quick way to shop for insurance quotes. In just a couple of minutes, you can explore disability insurance policies and how different features and options impact pricing.