The Short Answer

How Disability Insurance Can Protect Your Income

Karen Wallace, CFP®

What would you do if you were injured and couldn't work? Maybe you have an emergency fund with enough cash to cover your essential living expenses for three to six months (or longer).

But what happens if your illness keeps you out of work for longer than a few months? Or what if, as a result of an accident, you suffer long-term or permanent complications that render you unable to do your job forever? Unfortunately, these things happen.

If you suffer an injury or illness that renders you unable to work, the last thing you want or need is to add severe financial stress to the mix. Unfortunately, the reality is that medical bills are one of the top reasons people file for bankruptcy. 

What Are Your Options?
If you burn through all your cash and are still unable to work, you might qualify for a loan at a reasonable interest rate. Or, if you're lucky enough to have family and friends who are in a position to help, you could lean on them. You could also sell things you own to generate cash. None of these options is ideal, but they beat racking up a lot of debt at high interest rates with no means to pay it off. 

The best way to hedge against this risk for a reasonable cost, though, is to have a disability insurance policy. 

Employer-Offered Group Short-Term and Long-Term Disability Insurance
If your employer offers group disability insurance coverage, make sure you're signed up for it, and make sure you understand the coverage it provides. 

Short-term disability replaces a percentage of your compensation for a limited period of time (sometimes up to one year). Note that if your employer pays the premiums (or if you are paying the premiums with pretax dollars), the disability income you receive will be taxable.

Conversely, if you pay the entire premium with aftertax money, the income you receive will be tax-free. Likewise, if you pay a part of the premium with aftertax money, you will have to determine the percentage of the premium that was paid with aftertax money to determine how much of the benefit received will be taxable. (Here's an easy example: If you pay half of the premium amount with aftertax money, half of the income received will be tax-free.)

That's important because if your short-term disability policy will cover only 60% of your pretax salary, be aware that the taxes due will further reduce the benefit so you might not have as much income replacement as you thought.

Individual Disability Insurance for the Self-Employed
If you are self-employed, look into an individual disability insurance policy. Unlike a group plan, these types of plans don;t come with guaranteed underwriting so you have to qualify for the coverage through a physical health check and proof of earned income. 

I am not involved in the sale of insurance, but the research I've done indicates that a self-employed person can expect to pay between 1% to 3% for coverage (the younger and healthier you are, the cheaper the premiums). So, if you make $40,000 per year you could get a decent policy for around $400 per year. 

Similar to employer-provided disability insurance coverage, individual disability insurance coverage is based on a percentage of your salary. If you're self-employed, that number might be trickier to calculate. Start by estimating your monthly income and expenses. 

Also consider the following:

  • Which type of coverage will work best for you? A higher level of protection is offered by "own occupation” policies, which provide benefits in the event that you are unable to perform the functions of your pre-disability job. "Any occupation" policies, meanwhile, will not provide benefits if you are able to do any job, even if it's a much lower-paying job than you had before you became ill or injured. 
  • Do you understand the elimination period? How long will you have to wait after becoming ill or injured before the policy pays benefits? The shorter the elimination period, the more expensive the policy (90 days is common).
  • What is the benefit period, or how long will the policy pay out the benefits? Though you can get a policy that will pay out until retirement, the longer the benefit period the more expensive the policy. Three-and five-year policies are common. 

What About Workers Comp?
Workers compensation covers lost wages only if the injury or illness was directly work-related. But the majority of illnesses and injuries that render employees unable to work are not. Every year, more than 5% of working Americans experience a disability, and they shouldn't rely on worker's comp as a safety net. Some of the most common causes of short- or long-term disability include pregnancy-related complications; injuries to the back, spine, knees, and hips; mental health issues such as anxiety and depression; and cancer. 

Does Social Security Have Your Back?
Social Security disability benefits paid through the Social Security disability insurance program aren't easy to get. SSDI follows a very strict definition of disability; partial and short-term disabilities will not qualify you for benefits. In order to receive government disability benefits you must have a severe medical condition that's expected to last at least one year or result in death. 

In addition, you must qualify for benefits based on how many "credits" you've accrued, and your disability benefit is based on your average lifetime earnings. Go to (or set up) your individual account at mySocialSecurity.com to see if you have earned sufficient credit to qualify for benefits. If you qualify, you can find out your estimated payment, and you can use the provided link apply for SSDI benefits online.