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Personal Finance FAQ

What if You Can’t Work (and Not Just From Lack of Coffee)?

This is part of a series. If you have not read the articles that build up to this one, I recommend that you do so first.

This article is going to deal with another one of those topics which we hate to face – addressing what happens in case you’re not physically able to get up and go to work anymore.

As we discussed in the previous article, for most people, their biggest asset is the ability to earn an income. Death is one way which that ability is lost for a family, but another way is through some sort of long term disability. This article will cover the ins and outs of disability insurance, including what to look for in a disability insurance policy and how much to get covered for.

The first place that people typically look to for disability benefits is the Social Security Administration. You pay a tax with every paycheck to go towards Social Security, so you’d expect to receive some money from them if you become disabled.

The problem with Social Security disability payments is that a) they’re low, and b) they’re based on a strict definition of disability, meaning that you cannot work at all.

Here’s what the Social Security Administration has to say about how they define disability:[1]

“Disability” under Social Security is based on your inability to work. We consider you disabled under Social Security rules if:

  • You cannot do work that you did before;
  • We decide that you cannot adjust to other work because of your medical condition(s); and
  • Your disability has lasted or is expected to last for at least one year or to result in death.

 

For a doctor who can no longer practice the field of medicine but could still mop floors, there’s probably no Social Security disability.

The average Social Security disability payment in 2019 was $1,104.67 per month for the disabled worker, $355.55 for the spouse of the disabled worker, and $383.68 for a child of a disabled worker.

In short, relying on Social Security to cover your living expenses if you become disabled is a road to ruin.

Before we go further, let’s look at how the insurance industry defines disability and the types of policies that you can purchase.

What is Disability?

In general, there are two types of disability for the purposes of purchasing disability insurance.

Own Occupation Disability

This is a disability which prevents you from working in the occupation for which you have skills, training, expertise, and ability. It’s usually the job that you were actually doing at the time you become disabled. For example, a piano player who lost both hands in an accident would no longer be able to play the piano. That would be a true own occupation disability. Nowadays, many insurance carriers have modified the own occupation definition to offset against income received from performing work in another field. So, if said piano player became a piano teacher instead, that disability benefit may be reduced by the amount that the person is receiving in teaching income. It’s important that you read any policy which is presented to you so that you can understand what you would be paid for in the event of disability rather than just trusting the marketing materials which say “own occupation” coverage. The devil, as is almost always the case with insurance contracts, is in the details.

Any Occupation Disability

Most disability insurance contracts define any occupation as an inability to perform any gainful work, regardless of your skills, knowledge, experience, or education. Some are a little more lenient, defining the disability as an inability to perform equivalent or related work to your current occupation, based on your wages, history, and skills. However, many of them are now trending towards the definition which is closer to the Social Security Administration’s definition – whether or not you can do any work at all.

Other Key Disability Insurance Clauses

Elimination period

This is like a deductible in other types of insurance. It’s the period of time which you must wait between the time you become disabled and the time that you start claiming disability benefits. Typical elimination periods range from 3 to 6 months. The longer your elimination period, the lower your premiums will be, with all other things being equal. Naturally, a longer elimination period will also require you to have more liquid assets to live on.

Noncancelable / Guaranteed renewable

These are two sides of a similar coin. Noncancelable insurance means that the insurance cannot be cancelled for the period of the policy and that the premiums will remain the same. Guaranteed renewable means that you can continue coverage for as long as the premiums are paid, but the premiums could change over time.

Benefit period

This means how long the disability benefits will be paid. Most disability policies go until your Social Security Administration full retirement age and then stop, assuming that your savings and Social Security will cover the remainder of the income requirements. A few are life policies, and some are life policies only if you become disabled before age fifty. Finally, some have a limited term, such as paying benefits for five years.

There are also short-term disability policies which will usually only cover you for two years. I lump all disability policies together, since, in most cases, the only salient difference is length of time that the benefit period covers.

Monthly benefit

This is how much a disability insurance policy will pay. We’ll discuss this more in the next section.

Inflation or cost of living adjustments

This means how much your payments will increase every year. It’s important to be aware of the COLA (cost of living adjustments) rate for your policy, as you’ll need a source of money to keep up with rising costs over time. If you have sufficient assets to cover inflation by withdrawing from the gains of the assets, you may not need COLA adjustments; otherwise, you will want them, as inflation will ravage your purchasing power in the long run.

How Much Disability Insurance Should I Have?

In most cases, the default disability insurance policy is going to be 60% of your income. The reason for this number is that when you pay for your own disability insurance policy with after-tax dollars, then the disability benefits are not taxable. You paid for something with after-tax dollars, and what you receive from what you paid isn’t taxable in the IRS’s eyes. How generous, right? However, if your employer provides the disability insurance as a part of your benefits package or you pay for the insurance as a part of a cafeteria plan with pre-tax dollars, then your disability benefits, if you need them, will be taxable.

Therefore, the answer depends on how you’re paying for the disability insurance.

If you’re paying with after-tax dollars, then 60% is a pretty reasonable number for income replacement. You won’t have to pay taxes, and for most people, that will account for 20-25% of the income, and you won’t have to pay for the professional expenses of having a job: clothing, continuing education, commuting, and the like. The tradeoff is that your medical expenses will probably increase – you do have to be disabled to be able to receive the disability income benefit, after all – so your costs will go up. If you can get more than 60% and your assets aren’t sufficient to be able to cover the difference in costs (probably 10-20% of your income), then you should, as the incremental monthly premium won’t be that much higher.

If, on the other hand, you have a lot of assets and the loss of income wouldn’t dramatically affect your overall lifestyle, then you could get less than 60% of your income as a replacement benefit.

Your age is also a factor, which would be correlated to your assets in most cases. If you’re younger, then you’re going to need to rely on that disability benefit to not only cover your costs of living, but also to set aside money for when you’re older, kids’ education, and any other long-term monetary goals that you have. If you’re older, you should have already accumulated a reasonable amount of assets, which would mean that you could potentially get away with a lower income replacement.

Finally, how much you need will depend on how much you spend. If you’re making much more than you spend in a given month and you’re close to having enough assets to cover those expenses regardless of other income you bring in, you can aim for a lower benefit amount.

You may not think that you need disability insurance. People don’t like to address their own mortality or their own frailties. If you want a reasonable estimate of the chances of your own disability, then go to the Personal Disability Quotient calculator[2] and find out what your number is by clicking on that blue link. You’d probably be surprised. Even if you’re healthy, there’s probably about a 20% chance that you’ll miss time at work because of a disability. Disability insurance can be a reasonably cheap way to protect yourself.

My wife went through about a two month period where doctors suspected that she had multiple sclerosis. While multiple sclerosis is not the terminal diagnosis that some other diseases can be, it almost certainly would limit the amount of time that she could have worked. Fortunately, she had disability insurance through her employer, so we knew that her income was protected through that policy. Even though she was cleared of a potential diagnosis, having that peace of mind was very helpful as we dealt with the stress of a possible lifetime of dealing with the disease.

[1] https://www.ssa.gov/planners/disability/

[2] http://www.whatsmypdq.org/

The next article in this series is Don’t Pay an Arm and a Leg to Keep your Arm and Leg.

By

Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business.

You can read more about him in the About Page.

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