Understanding disability coverage you may already have

Through payment of employment-related taxes, you may have some disability coverage through state and federal government insurance programs. However, this coverage is more short term than long term in nature:

• State disability programs: A handful of states have disability insurance programs, but the coverage is typically Spartan. Benefits are paid over a short period of time (usually one year at most). State programs are also generally not a good value because of the cost for the small amount of coverage they provide.
• Social Security disability: Social Security pays long-term benefits only if you’re unable to perform any substantial, gainful activity for more than a year or if your disability is expected to result in death. Furthermore, Social Security disability payments are quite low because they’re intended to provide only for basic, subsistence-level living expenses. Also, if you’ve only been working for a short amount of time, you haven’t paid much into Social Security and thus won’t have a high level of earned benefits.

What about coverage you have through your employer? If you’re self-employed or work for a small company, you probably don’t have long-term disability coverage. By contrast, most large employers offer disability insurance to their employees. Ask your employer’s benefits department or person for details on your current policy and then compare those with the features that I recommend you get on a policy that you buy for yourself.

Workers’ compensation, if you have such coverage through your employer, pays out if you’re injured on the job, but it doesn’t pay any benefits if you get disabled away from your job. You need coverage that pays no matter where and how you’re disabled.

Determining how much disability insurance you need

You should carry sufficient long-term disability insurance coverage to provide you with adequate income to live on should you become disabled. If you don’t have many financial assets and you want to maintain your current lifestyle if you suffer a disability, get enough coverage to replace your entire monthly take-home (after-tax) pay.

The benefits you purchase on a disability policy are quoted as the dollars per month you receive if disabled. So if your job provides you with a $3,000-per-month income after taxes, get a policy that provides a $3,000-per-month benefit.

If you pay for your disability insurance, the benefits are tax-free (but hopefully you won’t ever have to collect them). If your employer picks up the tab, your disability benefits will be taxable, so you need a greater amount of benefits.

In addition to the monthly coverage amount, you also need to select the duration for which you want a policy to pay you benefits. You should select a policy that pays benefits until you reach an age at which you become financially self-sufficient. For most people, that’s around the age when their Social Security benefits kick in. (Folks born after 1959 get full Social Security benefits at age 67 and reduced benefits before that age.)

Identifying useful disability policy features

If you go shopping for a long-term disability (LTD) insurance policy, you need to master some jargon. LTD policies have numerous options, some of which you need and some of which you don’t. Here’s what you need to know:

• Definition of disability: An own-occupation disability policy provides benefit payments if you can’t perform the work you normally do. The extra cost of such policies is worthwhile if you’re in a high-income or specialized occupation and you’d have to take a significant pay cut to do something else (and the reduced income and required lifestyle changes wouldn’t be acceptable to you). Other policies pay you only if you’re unable to perform a job for which you’re reasonably trained.
• Noncancelable and guaranteed renewable: These desirable features ensure that your policy can’t be canceled because of your developing health problems.

• Waiting period: The lag time between the onset of your disability and the time you begin collecting benefits is a disability policy’s deductible.

  As with other types of insurance, you should take the highest deductible (longest waiting period) that your financial circumstances allow. A longer waiting period significantly reduces the policy’s cost. The minimum waiting period on most policies is 30 days. The maximum waiting period can be up to one to two years. Try a waiting period of three to six months if you have sufficient emergency reserves.

• Residual benefits: This useful option pays you a partial benefit if you have a disability that prevents you from working full time.
• Cost-of-living adjustments (COLAs): This feature automatically increases your benefit payment by a set percentage annually or in accordance with changes in inflation. The advantage of a COLA is that it retains the purchasing power of your benefits. A modest COLA, such as 3 percent, is worth having.
• Future insurability: This allows you, regardless of health, to buy additional coverage in the future. You may benefit from the future insurability option if your income is artificially low now and your career trajectory suggests that your income will rise significantly in the future.
• Insurer’s financial stability: Choose insurers that will be here tomorrow to pay your claim. But don’t obsess over the company’s stability; benefits are paid even if an insurer fails, because the state or another insurer almost always bails out the unstable insurer.

Shopping for coverage

When you start to shop for LTD, focus your attention first on group plans, which generally offer the best value. You may have access to buy group disability insurance through your employer or a professional association. Just be sure that the group plan policy includes the features I discuss and recommend in the preceding section.

If you don’t have access to a group policy, you’ll likely end up buying an individual policy through an agent. Some agents are called independent agents because they sell policies from numerous insurance companies. Other agents are dedicated to selling policies from a single company. Both types are fine to use so long as you shop the marketplace and get a cost-effective policy with the features that I suggest in the preceding section.

Tread carefully when purchasing disability insurance through an agent. Some agents try to load your policy with all sorts of extra bells and whistles to pump up the premium — along with their commission.

Assessing your current life insurance coverage

In a moment, I discuss how much coverage you may need if you’ve decided you need life insurance protection. First, though, take stock of your current coverage. Start with your current employer and determine whether the company offers you any life insurance coverage at its own expense.

Next, consider possible coverage you may have through Social Security that provides survivor’s benefits to your spouse and children. Be aware, however, that if your surviving spouse works and earns even a modest amount of money, he or she will get little, if any, survivor’s benefits. Prior to reaching Social Security’s full retirement age (67 for those born after 1959), your survivor’s benefits get reduced by $1 for every $2 you earn above $18,960 (in 2021).

If either you or your spouse anticipates earning a low enough income to qualify for survivor’s benefits, you should factor those benefits into how much life insurance to buy. For example, if your annual after-tax income is $40,000 and Social Security provides a survivor’s benefit of $12,000 annually, you’d need enough life insurance to replace $28,000 annually ($40,000 – $12,000).

The Social Security Administration (SSA) used to mail an annual statement to working adults that showed their earnings history and estimated future Social Security benefits. In an effort to save on printing and mailing costs, they no longer do this and only mail a statement to those age 60 and older who are not yet collecting benefits and who haven’t set up an online account through the SSA website. If you haven’t reviewed your earnings history and estimated Social Security benefits in recent years, be sure to set up an account through www.ssa.gov.

Determining how much life insurance to buy

To figure the amount of life insurance to buy, ask yourself how many years of income you want to replace. Table 15-1 provides a simple way to calculate how much life insurance you need to consider purchasing. To replace a certain number of years’ worth of income, multiply the appropriate number in the table by your annual after-tax income. Because life insurance policy payouts aren’t taxed, you need to replace only after-tax income and not pre-tax income.

You can figure your annual after-tax income in one of two ways. You can calculate it by getting out last year’s tax return (and Form W-2) and subtracting the federal, state, and Social Security taxes you paid from your gross employment income. Alternatively, you can estimate your annual after-tax income by multiplying your gross income by 80 percent if you’re a low-income earner, 70 percent if you’re a moderate-income earner, or 60 percent if you’re a high-income earner.

Deciding what type of life insurance to buy

Before you purchase any life insurance, you need to know your options. Life insurance comes in two major types:

• Term insurance: You pay an annual premium (as you do for your auto insurance), for which you receive a particular amount of life insurance protection. If you die during the term, your beneficiaries collect; otherwise, the premium is gone but you’re grateful to be alive!
• Cash value insurance: All other life insurance policies (whole, universal, variable, and so on) combine life insurance with a supposed savings feature. A portion of your premiums is credited to an investment account that grows in value over time.

Purchase low-cost term insurance and do your investing separately. Life insurance is rarely a permanent need; over time, you can reduce the amount of term insurance you carry as your financial obligations lessen and you accumulate more assets. Cash value life insurance can make sense for some people, such as small-business owners who own a business worth millions of dollars and who don’t want their heirs to possibly be forced to sell the business to pay estate taxes in the event of their death.

Insurance salespeople aggressively push cash value policies because of the high commissions that insurance companies pay them. That’s why these policies explicitly penalize you for withdrawing your cash balance within the first seven to ten years. You’re paying for these high commissions when you buy one of these policies. Also, you’re more likely to buy less life insurance coverage than you need because of the high cost of cash value policies relative to the cost of term. The vast majority of life insurance buyers need more protection than they can afford to buy with cash value coverage.

Shopping for life insurance

You can purchase term life insurance so that your premium increases annually or it increases after 10, 15, 20, 25, or 30 years. The advantage of a premium that locks in for, say, 20 years is that you have the security of knowing how much you’ll be paying each year for the next two decades. You also don’t need to go through medical evaluations as frequently to qualify for the lowest rate possible.

The disadvantage of a policy with a long-term rate lock is that you pay more in the early years than you do on a policy that adjusts more frequently. In addition, you may want to change the amount of insurance you carry as your circumstances change. Thus, you may throw money away when you dump a policy with a long-term premium guarantee before its rate is set to change. Policies that adjust the premium every five to ten years offer a balance between price and predictability.

Be sure to get a policy that’s guaranteed renewable, which assures that the policy can’t be canceled because of your health worsening. Don’t buy a life insurance policy without this feature unless you expect that your life insurance needs will disappear when the policy is up for renewal.

Here are some sources for high-quality, low-cost term insurance (the first three are independent agencies):

• AccuQuote: www.accuquote.com; 800-442-9899
• ReliaQuote: www.reliaquote.com; 800-940-3002
• Term4Sale: www.term4sale.com; 888-798-3488 (this company provides quotes and refers you to agents who sell life insurance in your area)
• USAA: www.usaa.com; 800-531-8722 (this company sells low-cost term life insurance directly to the public; some of its other insurance products are only available to members of the military and their families)