Income Replacement with Disability Insurance

Most individuals understand the need for traditional life insurance. It pays a death benefit in the event a loved one, such as a spouse, dies prematurely. The death benefit is there to provide income for expenses, and to fund future expenses such as college or the surviving spouse’s retirement.

While not overlooked, a seldom though about income replacement tool is disability. Disability insurance should not be ignored, and arguably should be considered as a higher priority than life insurance. This is because statistically, an individual has a higher chance of becoming disabled, than dying prematurely. Especially if they’re young.

Most disability policies are offered through an employer as benefit for employees. Typical policies provide 60-70% of income replacement in the event the covered employee becomes disabled.

When initially getting disability insurance, it’s important to pay close attention to the definition of disability in the policy. This definition will determine whether the policy will pay or not, for being disabled.

For example, a policy with a definition of “own occupation” will provide disability benefits in the event the insured becomes disabled and cannot perform the duties of their own occupation. This definition is critical for occupations such as surgeons, doctors, and other professions that are specialized.

Another definition is “any occupation”. A policy with this definition will only pay when it’s deemed the insured cannot perform the duties of any occupation. This is a very strict definition and it’s much more difficult for the insured to have the policy pay. Social Security’s definition of disability is any occupation.

The premiums between the two definitions are different as well. With own occupation, the premium will be more expensive than any occupation. This is because the own occupation policy is more likely to pay in the event of a disability. But again, the extra premium is worth it for specialized occupations with high incomes to protect.

When deciding on a policy, be sure to check the elimination period. The elimination period is analogous to a “time deductible”. In other words, how long the insured must wait after becoming disabled to receive benefits. Elimination periods range from 30 to 180 days. The longer the elimination period, the cheaper the premium and vice versa.

Choice of elimination period may coincide with how much is in the emergency fund (generally 3 to 6 months of expenses).

Finally, taxation of benefits will depend on how premiums are paid. If an individual pays premiums with after-tax dollars, then any benefits received are tax-free. If an employer pays the premiums, the employer can tax a tax deduction and any benefits received are taxable to the employee. If benefits are paid by the employee on a pre-tax basis (as part of a benefit plan), then any benefits received are taxable.