How much disability insurance do I need?

By Chris Couch Posted : 01/24/2011

Disability insuranceNext time you're in a public place, look around. For every three people, on average one will become disabled before retiring, according to the Portland, Maine-based Council for Disability Awareness.

That is why disability insurance – a product that replaces part of your income if you can't work due to injury or illness – should be part of your long-term financial strategy, says Barry Lundquist, president of the council.

To figure out how much disability insurance you'll need, start by looking at your options for purchasing this coverage.

3 types of disability insurance

Disability insurance plans come in three basic varieties:

  • Employer-sponsored group plans in which an employer pays all or part of the yearly
  • Group plans that you purchase through an employer
  • Individual policies that you purchase on your own

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Lundquist says all three types of plans typically replace 60 percent of your income, although group plans frequently have income caps and will only reimburse your income up to $50,000. Higher earning staff who need insurance beyond the income cap will have to pay for supplemental disability insurance on their own.

Lundquist adds that the three types of plans vary significantly in price, with individual policies costing between 1.5 percent and 2.5 percent of your yearly income, group policies costing around 1 percent, and employer-sponsored plans costing approximately 0.5 percent.

"If the employer is paying the premium, the benefit is also taxable," says Laura E. Hahn, director of individual products strategy for the Pittsfield, Mass.-based Berkshire Life Insurance Co. of America, a subsidiary of the Guardian Life Insurance Co. of America that specializes in disability claims.

How much disability insurance do you need?

When determining how much disability insurance you need, Hahn says you should examine your income, then determine how much you'd need in benefits to "cover saving for retirement, [your] children's education expenses, living expenses."

When estimating disability coverage needs, calculate how much after-tax benefit you'll receive and evaluate whether your family could survive on that amount when it's added to your partner's salary, Hahn says.

In many cases, the answer is no. If that's true for you, it might be wise for you and your partner to each purchase individual disability insurance policies. Or, the primary breadwinner should opt for a high level of coverage.

Lundquist says you should also weigh how long you'll receive benefits. Many disability insurance policies are available in two- and five-year increments. Or you can opt for coverage until you turn 65 and start collecting retirement.

The latter is a good option for many people, Lundquist says.

"That's going to be the cheapest option and give you the most benefit," says Lundquist, adding that shorter policies are significantly more expensive. Premiums for a two-year policy often are double that of policies that cover to age 65.

"We only recommend shorter plans if that's all the policyholder can afford," Lundquist says.

When does your disability insurance kick in?

When shopping for disability insurance, it's also crucial to closely examine how a policy defines "disability." Some plans will cover you if you cannot return to the specific job you held before becoming disabled. Other plans only offer a benefit if you can't work any job.

"That means that if you can flip burgers at McDonald's, you're not considered disabled," Lundquist says. "You wouldn't get a benefit at all, even if you were a doctor before and had a much higher salary."
 
Also, be aware that unlike health insurance, disability coverage does not kick in immediately after you become disabled. Instead, you must wait through an "elimination period" – usually ranging from one month to one year – before getting paid.

The longer the elimination period, the cheaper the policy will be. The downside of a longer elimination period is that you'll be forced to cover your expenses out of pocket for a longer period of time following a disabling event.

"The typical elimination period is 90 days, but that takes a bit of savings," says Hahn, who adds that "you really have to think about what you can afford if you become disabled and what you can't."

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