Disability Insurance: How to Protect Your Income

Time to Read: 7 Minutes

Most working people tend to do a decent job addressing their life insurance and health insurance needs. However they often forget to give the same care and attention to disability insurance. Studies show that you are much more likely to become disabled then die during your working years. Whether you own your own business or work for an employer, you need to prioritize protecting your income from an illness or injury that prevents you from working.  

Read on to understand how disability insurance works, why it is important to consider purchasing, and what you need to know when assessing your disability insurance needs.    

Disability Insurance Basics

What is disability insurance?

Disability insurance pays out a portion of your income if you were unable to work due to illness or injury. Sometimes referred to as “income protection insurance” or simply “DI,” disability insurance protects you against the risk of being unable to work.   

What are the different types of disability insurance?

There are two types of disability insurance – short-term and long-term. They both replace a portion of your income but have different benefit periods. Short-term coverage has a short waiting period and pays out a higher benefit but only for a short period of time, typically less than a year. Long-term disability insurance has a longer waiting period and pays out a smaller monthly benefit, but the coverage extends for a much longer period of time. There is a laundry list of different provisions and riders that you can add to your disability coverage to customize your policy to your needs. Provisions are changes that are made inside the insurance contract and riders are benefits added on to the contract after the fact.   

What qualifies as a disability?

An insurance policy’s definition of “disability” varies depending on the type of coverage you have. The three most common types of coverage are “own occupation”, “modified any occupation”, or “any occupation”. With an “own occupation” policy you are considered to be disabled if you can no longer work your current job – think of a professional baseball player who breaks his arm. A “modified any occupation” policy pays out if you cannot work your current job or any other occupation in which you are reasonably fit by education, experience, or training. An example of this policy not paying out would be if you are a pilot and injure your legs and cannot fly planes anymore but you could teach piloting lessons on a flight simulator. An “any occupation” policy only pays out if you can no longer work your job or any other job, regardless of what field it is in or what it pays. In the case of the baseball player who breaks their arm, they would be out of luck with an “any occupation policy” because they could still collect tickets at the movie theatre. This is the most restrictive definition of disability and it takes a serious injury or even incapacitation for these policies to pay out. Other types of disability policies exist and are a blend of the three disability definitions mentioned above.   

How are disability insurance benefits taxed?

Taxation depends on who pays the insurance premiums. If you get disability insurance through work and your employer pays the premium, the benefits are taxable to you, the employee. If you pay the insurance premiums, for either your personal policy or the one offered by your employer, and pay with after tax dollars, the benefits are non-taxable. 

How Much Disability Insurance Should I Purchase? 

The general rule of thumb is to have enough disability insurance to replace approximately 60% to two-thirds of your gross income if you became disabled and could not work. While 60% income replacement is a good place to start, there are several different factors that should be considered.  

For example, do you have other assets or sources of income that can protect you if you were to become disabled? Married couples who both work benefit from the fact that if one spouse becomes disabled, the other spouse can still provide a stream of income for the household. Single workers do not have this luxury and will need more disability insurance. Moreover, the more people that rely on your income the greater your disability insurance needs. An employee who is the sole breadwinner of a family with three young children has a much higher insurance need than a single worker. 

 Although less obvious, your investments are another source of income replacement that should be factored in as you decide how much disability insurance you should have. As your net worth grows, your need for insurance declines since you can tap into your investment accounts to help pay your bills while you recover. People with large investment portfolios and high net worth tend to be older with fewer working years remaining and therefore demand less future income protection. On the flip side, younger workers typically have smaller investment portfolios with many working years ahead of them and thus have a bigger need for disability insurance to protect their income.   

Your need for disability insurance will vary based on the type of work you do. Someone who relies heavily on their body to do their job, like a surgeon or an athlete, has a much higher need for disability insurance than someone who works behind a desk. At BWM Financial we think it is important to talk to a financial advisor to help you assess how much disability insurance you should carry, and find the best options for purchasing that insurance.   

Steps to Building Adequate Disability Insurance Coverage 

Let us assume that after much deliberation you decide that you need to buy enough disability insurance to cover 60% of your income. Here are our recommended steps on how to achieve that level of protection. 

1. Disability Insurance – First, you want to utilize the insurance available to you through your employer. More times than not, the disability coverage offered as a part of your employer’s group health insurance plan will be better than what you can get on the open market, because employers often offer below market premiums to employees, or pay for the premiums entirely. There are limits to the amount of income an employer plan will cover and until recently, these limits were relatively small and hovered around $4,000 a month. However, the income protection limits on employer disability insurance plans have risen significantly in recent years and many large employers offer income replacement up to $15,000 a month, which is adequate coverage for anyone making $300,000 or less.If you are self-employed, a gig economy worker, or work for an employer that does not provide disability insurance then you have no other choice then to go to the open market. There are many different insurance providers, such as Northwestern Mutual or Guardian. We recommend sticking to the large, well-established firms and involving a financial advisor to help guide you when choosing which policy to buy. Keep in mind that these policies also have limits on the amount of income replacement they will provide. 
2. Individual Disability Insurance – If your long-term disability insurance, bought either through your employer or on the open market, does not cover your 60% desired income replacement, your next step is to buy Individual Disability Insurance (IDI) to cover this shortfall. IDI policies are insurance with higher income-protection limits then normal long term disability policies. They also can insure other sources of income that normal disability policies do not cover, like commissions and bonuses. Many executives, and high-income earners buy these policies to bridge the gap between their normal disability benefits and their desired income protection amount.For example, someone making $500,000 a year who wants 60% of their income covered needs to protect $300,000 of earning power. If they can get $15,000 a month ($180,000 a year) through their employer, they will have a shortfall of $120,000 which could be covered by buying an IDI policy for that amount. However, just as with long-term disability policies, individual disability insurance policies have income protection limits. 
3. High Limit Disability Insurance – In most cases, anyone earning $500,000 or less will be able to find adequate protection by combining normal long-term disability insurance with an individual insurance policy. The highest tier of protection is called high limit disability insurance and is only offered by a few underwriters worldwide, the largest being Lloyds of London. High limits plans are negotiable and highly customizable and have nearly infinite income ceilings and benefit payouts depending on the person. Athletes, CEO’s, special doctors and surgeons are common clients for these types of policies. 

Other Considerations 

• Factor in some intangibles when you are determining how much insurance you need. What is your appetite for change? Would you consider to be a flexible person? Some people are very willing to make changes if things do not go their way, and thus need less insurance because they know they can always alter their lifestyle if they became disabled or pursue a new career with different physical demands. Others like their life the way it is, do not ever want to make a change, and are more comfortable spending a bit more money on better disability insurance policies to pay up for this security. 
• Do not rely on social security for disability insurance. If you think that the government will foot the bill, think twice. Social security benefits do have a disability component, however they are notoriously difficult to qualify for and the payout is only marginal. Consider social security as the back-up to your back-up.   
• COVID and the newfound ability for people to work from home has changed the game with regards to disability insurance claims. Most policies will not pay out unless you become disabled and your earned income dips below a given threshold, commonly 75% of your pre-disability income. If you become disabled and are bed ridden but can still do at least 25% of your work duties while down, your disability insurance may not kick-in. 

A Wholistic Approach to Insurance  

Whether it is a surf trip gone wrong, or neck or back complications that require surgery, disability insurance can help replace income while you recover. BWM Financial advisors have first-hand experience helping people determine how much insurance they need, and the best ways to get that coverage. BWM Financial is a fiduciary practice that does not sell insurance products. This allows us to best serve, educate, and advocate for our clients so they can get the best insurance for their needs.  We take a comprehensive approach client’s insurance needs, factoring in client asset levels, age, family, preferences and risk tolerance. Please reach out to us if you would like an insurance consultation from our team.  

Investment advice offered through Stratos Wealth Partners, Ltd., a Registered Investment Advisor DBA BWM Financial.  The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.