Imagine you had a machine that sat in the corner of your office and generated the equivalent to your entire annual salary. It dependably spits out money, month after month, year after year, without fail. Would you purchase a warranty on that machine? Would you call your insurance agent and buy an insurance policy to protect your money machine? Of course you would.
Well, that machine is you. A disability policy provides the assurance that your “machine” can continue to generate a consistent income each and every year, if you become sick or injured and unable to work. Most of us have purchased a life insurance policy or have one that is provided to us at work. However, many do not own any disability insurance, or are woefully underinsured. I believe that disability insurance is equally important, if not more vital than life insurance. Whether you are married, single, with or without children, owning a disability insurance policy is critical to your financial security if you rely on your earned income to pay your bills. Once you can afford to retire, you no longer have the need for coverage and can let it go. (Full Disclosure: As a Certified Financial Planner, I do sell disability insurance.)
How Much Do I Need?
You should own enough disability insurance to pay your non-discretionary expenses. If disabled, you might not be able to afford vacations or entertainment, but you will still need to pay your mortgage or rent and utilities. [Editor’s note: Failing to pay loans and everyday bills can seriously damage your credit scores and subject you to debt-collection activity. To keep an eye on how your credit is faring, you can get two free credit scores with regular updates from Credit.com.]
In my experience reviewing my clients’ policies, most disability insurance companies limit the payout to 60% to 75% of your pre-tax income. The reason for this limitation is that they do not want to incentivize you to become disabled. Obviously, most of us do not want to be disabled, but fraudulent claims are always a possibility with unscrupulous people. If you pay the disability insurance premium with after-tax income, then a 60%-to-75% benefit could replace most, if not all, of your after-tax take home pay.
What If I Already Have Benefits at Work?
If your employer provides disability insurance for you, consider yourself one of the fortunate few. According to 2014 data from the Bureau of Labor Statistics, only a third of American workers (in the private sector) have long-term disability through their employer.
If your income includes a bonus, chances are that bonus is not covered. As I review my clients’ employee benefits, I have seen that most of the disability benefits only cover the base salary and do not include the bonus. So if your total compensation of $70,000 comprises $60,000 in base salary and a $10,000 bonus, your annual benefit would likely be between $36,000 and $45,000. If your employer pays all of the cost of this benefit, then the disability payments to you would be fully taxable. You could, however, purchase additional coverage on your own to cover the bonus. Typically you might qualify for at least an additional $7,000 to cover your bonus, bringing your total disability benefit up to $43,000 to $52,000 per year.
Disability insurance isn’t cheap: There are many factors, including age, gender and occupation, that can significantly affect the premium; you can easily pay 1% to 3% of your annual income for it, but not having it when you need it could be devastating to your finances.