Many financial planners and advisors tell their clients that their ability to earn an income is their greatest asset. This can be especially true for those who are highly compensated, such as medical practitioners, business owners and executives.
Losing this ability due to sickness, injury or other misfortune can be financially devastating, even if it’s only for only a few years. Insuring against this loss is one of the foundational elements of financial planning for just about anyone who earns substantially more than the minimum wage.
Likelihood of Becoming Disabled
One of the key facts that many people are unaware of when it comes to disability is that it is far more likely to occur than premature death. Protectyourincome.com has published a table that shows that it is statistically more than twice as likely that the average 30-year old will become disabled rather than die at that age. While the odds of disability decrease over time, they always remain higher than the chance of early death, even at age 55. The financial consequences of disability can be exponentially larger than for someone who dies. (For related reading, see: Types of Social Security Benefits.)
A quick example: Joe is 35 years old. He makes $75,000 a year and is killed in a car crash. He has $500,000 of life insurance. His widow uses the money to pay the remaining medical bills and pay off the house. She deposits the remainder into the 529 plans that they established for their two kids.
Frank is also 35 years old and married with two kids. He experiences a car crash but survives. However, he is permanently mentally incapacitated and will never be able to work again.
This comparison graphically illustrates the enormous difference between the economic consequences of death and disability. Joe’s bills ended quickly, and his life insurance provided adequate compensation. But Frank’s medical bills are just beginning and may well continue for decades to come. After the initial doctor and hospital bills arrive, there may be an ongoing need for managed care of some sort, which can cost thousands of dollars per month. Life insurance will not cover this type of expense because there was no death. If Frank lives on to age 70, then the total cost of care for him could easily run into the millions. (For more, see: Are All Disabilities Treated the Same for SGA Thresholds?)
Fortunately, there is a type of insurance coverage available for those who become unable to work. Disability insurance is offered by life and disability carriers for both individuals and groups. This type of coverage pays out a monthly benefit to the insured while they are disabled in order to replace their lost income. In most cases, this type of benefit will cease at age 65, which is considered retirement age. Disability coverage is divided into two main categories. Short-term coverage is for disability periods that last for less than two years, while long-term disability insurance covers longer periods up to a lifetime.
Disability Policy Characteristics
The following characteristics can be found in most disability policies:
- Capital Sum Benefit. Many policies will pay out a lump-sum benefit to insureds for certain events, such as the loss of an eye or a limb. This can be in addition to any monthly benefits to which the insurance may also be entitled.
- Renewability Clause. Disability policies can offer various levels of guarantees of renewability for their coverage in a manner similar to life insurance. Guaranteed renewable policies are the most expensive. Non-cancellable policies also promise that the provisions and premiums in the policy will never change once it is issued if premiums are paid. (
- Elimination Period. Most disability policies will not pay out until a certain period of time has elapsed, such as 90 days. This waiting period is the equivalent of the deductible for these policies.
- Waiver of Premium. This benefit is essentially the same as with life insurance policies, where the insured can pay for an additional rider that allows them to not have to pay the policy premiums while they are disabled.
All disability policies will define the level of disability coverage that they offer. Total disability will pay a higher benefit for those who are completely unable to work, while residual disability will pay a partial benefit to those who are still capable of some level of gainful employment. Own-occupation disability is more expensive and will replace the income that was earned by the insured in their respective lines of work. Any occupation coverage only pays a benefit if the insured is unable to work any gainful employment for which they are suited by training, education or experience. True Own Occupation coverage is the best-and most expensive-type of coverage. This type of coverage will pay the difference between the actual earnings of the insured and any income that they are able to earn in a lower-paying job if they become partially disabled.
Taxation of Disability Insurance
The tax rules for disability coverage are fairly straightforward. All benefits that are paid from these policies are unconditionally tax-free as long as the policy owner did not deduct the cost of premiums paid as a medical expense. If the premiums were deducted, then the benefits are taxed as ordinary income as long as they are paid. For this reason, most planners will suggest that policy owners refrain from making this deduction, as having to pay tax on this form of income may be burdensome during a period of disability.
Small business owners who jointly own an enterprise often buy disability policies on each other in order to ensure the continuation of the business if one or more of them becomes incapacitated. These plans are often piggybacked on top of buy-sell agreements that are funded with life insurance contracts.
Accelerated Benefit Riders
Many life insurance policies now offer a form of disability protection in the form of an accelerated benefit rider. This rider will pay out a monthly benefit in the event that the insured becomes chronically ill. This benefit is usually triggered when the insured becomes unable to perform two out of the six activities of daily living (ADLs). Although this form of coverage does not exactly correlate with true disability insurance, it is becoming a popular alternative because it provides several types of benefits in one convenient package, and this benefit can last past age 65 in a permanent policy that becomes paid up.