Understanding the Importance of Disability Insurance

In life, we often take steps to protect ourselves against unforeseen circumstances - we insure our homes, our vehicles, and our health. We often forget to give the same care and attention to the protection of our income in the event of a disability. Disability insurance provides financial protection in case injury or illness prevents you from working. In this article, we'll delve into the significance of disability insurance and why it's an essential component of any comprehensive financial plan.

What is Disability Insurance?

Disability insurance, often referred to as disability income insurance, is a type of coverage that provides financial benefits to individuals who are unable to work due to a disability. This disability may result from injury, illness, or a medical condition, and it can be temporary or permanent in nature.

Why is Disability Insurance Important?

Income Protection

For many, your ability to earn an income is one of your most valuable assets. Disability insurance ensures that you continue to receive a portion of your income if you're unable to work due to a disability. This financial support can help you cover essential expenses such as mortgage or rent payments, utility bills, groceries, and other day-to-day costs.

Maintaining Financial Stability

A sudden loss of income due to disability can significantly impact your financial stability. Disability insurance provides a source of income replacement, allowing you to maintain your standard of living and meet financial obligations without depleting savings or retirement funds.

Covering Medical Expenses

In addition to replacing lost income, disability insurance can help cover medical expenses associated with your disability. This includes costs related to doctor visits, hospital stays, medication, rehabilitation services, and adaptive equipment.

What are the Types of Disability Insurance?

The spectrum of disability insurance encompasses two primary categories: short-term and long-term coverage.

Short-Term Disability Insurance

This variant furnishes benefits over a finite span, typically spanning from several months to a year following the emergence of a disability and satisfaction of the required waiting period under the policy.

Long-Term Disability Insurance

In contrast, long-term disability insurance provides financial assistance over an extended duration, which will end when the disability ends or often until the individual reaches retirement age, should the disability render them incapable of engaging in sustained employment. Again, the benefits will not begin to pay until after the required wait period under the policy, which is often 90 days.

Within these frameworks, three prevalent types of coverage emerge: "own occupation," "modified own policy," and "any occupation." Under an "own occupation" policy, disability is recognized if the individual can no longer fulfill their present job responsibilities. For instance, a professional athlete sustaining an arm injury would qualify under this provision. Meanwhile, a "modified own policy" disburses benefits if the individual cannot perform their current occupation or any other job commensurate with their education, expertise, or training. Consider a scenario where a pilot sustains leg injuries, precluding them from flying aircraft, but they could still impart piloting lessons using a flight simulator. In contrast, an "any occupation" policy only triggers benefits if the individual is unable to undertake their current role or any alternative employment, irrespective of industry or salary level. An “any occupation” policy is a type of disability insurance that provides coverage for when the insured is unable to work in a job suitable for them based on education, experience, and age. If the insured is capable of still working, even if it is at a lower-paying job, an “any occupation” policy would not pay benefits.

Additionally, there exist hybrid disability policies that amalgamate aspects of these coverage types.

How are Disability Insurance Benefits Taxed?

Disability insurance benefits can be subject to taxation, but whether they are taxable depends on how the premiums for the insurance policy were paid.

Employer-Paid Premiums

If your employer pays the premiums for your disability insurance policy, any benefits you receive will generally be taxable as income. This is because the premiums were paid with pre-tax dollars, so the benefits are treated as taxable income when received.

Employee-Paid Premiums (After-Tax)

If you pay the premiums for your disability insurance policy with after-tax dollars, meaning you've already paid taxes on the income used to purchase the policy, then any benefits you receive are typically not subject to income tax. Since you've already paid taxes on the premiums, the benefits are considered tax-free.

Employee-Paid Premiums (Pre-Tax)

In some cases, employees may have the option to pay disability insurance premiums on a pre-tax basis through their employer's cafeteria plan or flexible spending account (FSA). If you pay premiums with pre-tax dollars, the benefits you receive will generally be taxable income.

Government Disability Insurance: Benefits received from government disability insurance programs, such as Social Security Disability Insurance (SSDI) or Supplemental Security Income (SSI), may be subject to taxation depending on your total income.

It's important to note that tax laws regarding disability insurance benefits can be complex and may vary depending on individual circumstances and changes in tax legislation. Consultation with a tax advisor or financial professional can provide personalized guidance based on your specific situation. Additionally, the insurance provider or employer sponsoring the disability insurance policy may be able to provide information regarding the tax implications of benefits received.

How Much Disability Insurance Should I Purchase?

Determining how much disability insurance to purchase depends on various factors unique to your individual circumstances. Here are some considerations to help you determine the appropriate amount of coverage:

Income Replacement Needs

Calculate how much of your income you would need to replace if you were unable to work due to a disability. Many insurance professionals suggest aiming for coverage that replaces at least 60-70% of your pre-disability income. We recommend that you discuss this calculation with a licensed agent.

Living Expenses

Consider your monthly living expenses, including mortgage or rent payments, utilities, groceries, transportation, insurance premiums, and other essential costs. Ensure that your disability insurance coverage is sufficient to cover these expenses during a period of disability.

Debt Obligations

Take into account any outstanding debts, such as loans, credit card balances, or car payments. Disability insurance can help ensure that you can continue making these payments even if you're unable to work.

Healthcare Costs

Factor in the cost of healthcare and medical expenses associated with your disability. This may include doctor visits, prescription medications, rehabilitation services, and other healthcare-related costs not covered by insurance.

Savings and Emergency Funds

Assess your current savings and emergency funds. Disability insurance should complement your existing financial resources, providing additional protection against income loss due to disability.

Elimination Period

Consider the waiting period, known as the elimination period, before disability benefits kick in. You may choose a shorter or longer elimination period based on your savings and ability to cover expenses during that time.

Other Sources of Income

Take into account any other potential sources of income during a disability, such as savings, investments, spousal income, or government disability benefits. Disability insurance should fill the gap between your existing resources and your income replacement needs.

Future Financial Goals

Consider your long-term financial goals, such as retirement savings or children's education funds. Disability insurance can help protect these goals by ensuring that you can continue saving and investing even if you're unable to work temporarily or permanently.

What Action Should I Take?

It's essential to review your disability insurance needs regularly, especially when experiencing significant life changes such as marriage, the birth of a child, a career change, or an increase in income. Consulting with a financial advisor or insurance professional can provide personalized guidance tailored to your specific financial situation and needs. They can help you assess your risk factors, explore available coverage options, and determine the optimal amount of disability insurance to purchase. Investing in disability insurance today can offer invaluable protection for tomorrow.

Consider consulting with a financial advisor or insurance professional who can provide personalized guidance and help you navigate the process of building adequate disability insurance coverage. SPW Advisors have first-hand experience helping people determine how much insurance they need, and the best ways to get that coverage. SPW is a fiduciary practice that does not sell insurance products. This way we can best serve, educate, and advocate for our clients as they work with insurance professionals so they can get the insurance best suited for their needs. We take a comprehensive approach to 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.

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Disclosures:

Stratos Private Wealth is a division through which Stratos Wealth Partners, Ltd. markets wealth management services. Investment advisory services offered through Stratos Wealth Partners, Ltd., a registered investment adviser. 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. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. Investing involves risk including possible loss of principal. Some of the information contained herein has been obtained from third party sources which are reasonably believed to be reliable, but we cannot guarantee its accuracy or completeness. The information should not be regarded as a complete analysis of the subjects discussed.

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