Disability Income Insurance
Disability income insurance pays a regular income to an insured person who becomes totally disabled and unable to work. The amount the disability income policy pays is never as much as the person could be earning at work. Instead, each payment represents a percentage of the insured person's regular income.
Different insurance companies offer policies that may pay from 40% to 70% of the disabled person's gross income. A common percentage is 66-2/3%.
Suppose a person earns $1,000 per week and disability payments are made weekly.
- If the policy pays at 50%, the disability income payment for one week will be $500.
- If the policy pays at 66-2/3%, the payment will be $667 per week.
Disability income policies define exactly what constitutes a total disability that will trigger payments. There can be substantial differences in how disability is defined, so it is important to read the definition carefully. Most current policies use a two-step definition.
- First, total disability is defined as the inability of the insured to perform the duties of his or her own occupation for a specified period of time. Amanda is a physician specializing in thoracic surgery. This is the definition in her disability policy, and the period of time is two years. If Amanda is unable to continue her practice for two years because of disability, she is considered totally disabled during this time.
- Second, after the specified period ends, total disability is redefined as the inability to perform duties of any gainful occupation for which the insured is reasonably suited by education, training or experience. After the two years pass, Amanda is still unable to resume her surgical practice, but she is able to teach at a local medical school. At this point, Amanda is no longer considered totally disabled.
This is an example. Some insurers use more restrictive definitions. It is very important to read the definition in a particular disability income policy.
Following a total disability, an insured may recover enough to be considered just partially disabled. Policies may provide a reduced benefit for a partial disability, which is usually defined as the insured's inability to perform one or more of the important duties of his or her occupation. This partial disability benefit is commonly called a residual benefit.
A residual benefit is usually payable only if the insured, though able to return to work, is unable to earn at a level at least equal to the income he or she was earning before becoming totally disabled. The policy specifies that if earnings are reduced at least by a certain percentage of pre-disability earnings, usually 20% to 25%, a residual benefit will be paid. If the physician, Amanda, previously earned $10,000 per month, and after the total disability she is able to earn just $6,000 per month, she would qualify because her income is reduced by more than 25%, assuming that is the percentage stipulated in her disability income policy.
The amount of the residual benefit is determined by multiplying the percentage of income lost by the regular monthly total disability benefit. Suppose Amanda's total disability benefit was $7,000 and her income is now reduced by 40%. Her residual benefit will be 40% X $7,000 or $2,800.
Some policies provide a minimum guaranteed benefit during the first 6 or 12 months of residual disability. Typically, such a policy will pay 50% of the total disability benefit during this period.
Before any disability income benefits are paid, the insured generally must be totally disabled beyond a certain waiting or elimination period. During this period, the insurance company pays no benefits. If the disability continues at the end of this period, disability income payments begin.
Insurers offer a range of elimination periods. The most common are 30 days, 60 days, 90 days and 120 days. Periods of 180 days and one year might also be available.
The shorter the elimination period, the more the policy will cost since the insurance company will become obligated sooner rather than later. With a longer elimination period, there is a greater chance the insured will recover before payments begin, or soon after payments begin, so the premium will be less. The period during which the insured receives disability income payments is known as the benefit period. Several options may be available. Common periods are for one year, two years, five years, to the insured's age 65, and lifetime. The longer the benefit period, the more costly the policy.
There is a tax advantage when an individual purchases a disability income policy directly from an agent or when an individual pays the premiums even when the policy is offered through an employer plan. Here are three possible scenarios:
- When the insured individual pays the premiums, while they are not tax-deductible for the individual, any benefits paid when the insured is disabled will be received federal income tax-free.
- When an employer pays premiums on a disability income policy available under a qualifying plan, the insured employee must pay federal income taxes on any benefits received. However, the amount of the premium paid by the employer is excluded from the employee's taxable income in the year paid. The premiums are tax-deductible by the employer.
- When the employer and the employee share in the premium payments, the portion of any benefits paid for by the employee are received tax-free, but the portion paid by the employer must be reported as income in the year the employee receives benefits. The employer's contribution is excluded from the employee's taxable income, and the employer's contributions are tax-deductible by the employer.
Healthy wage earners may have to be convinced of the need for disability income insurance. Yet, insurance industry statistics reveals some startling facts about disabilities.
Of every 1,000 people, the percentage who will be disabled for at least 90 days before they reach age 65* are:
|At Age||Percentage Disabled|
The risk of becoming disabled is far greater than the risk of dying during these same years. For a 27-year-old, that risk is nearly three times greater than the risk of dying.*
These large percentages, even at the younger ages, indicate how very important it can be to insure the ability to earn an income.