Disability Insurance Deep Dive: What It Is and How It Works

As a professional service owner, your time is your most valuable asset. More directly, the income you earn by trading it for money is what makes the journey to your financial goals possible. FYI, you can save as much as you want for those goals. However, if that income isn’t protected, you’re at risk.

You need a financial plan. In fact, you need one that specifically includes protecting your savings and assets. The first and most important piece of any protection plan—for your personal finances or your business—is protecting your income.

So, what does that mean and how can you do it? That’s what we’ll aim to answer today.

This article answers the following questions (and more):

• How do I insure my income?
• How do I qualify for a claim?
• How much does my disability insurance pay?
• How long does disability insurance last?
  

Recognizing Your Risk

Before we discuss the ways to protect your cash flow, I think it’s helpful to illustrate the risk that you face. Put simply, if your income stops, all of your plans will be put on pause. For example, let’s say that you earn $500,000 per year and plan to save $200,000 of that for the next 10 years.

This puts you well ahead of most savers and will allow you to retire early (if you choose) by age 55. That’s a great plan. However, if you can’t work, both your current lifestyle and your future one are put at risk.

In the event that you can’t work, you now have $0.00 in income and $0.00 in savings—and that’s what we are focused on protecting you against. Once your income is protected, then you can put together a savings plan.

This is one of the greatest risks you face as the owner of a professional service. With that being said, let’s consider what you can do to protect your livelihood.

How Do I Insure My Income?

1. Be self-insured. The first and best option is to have enough passive income to replace what you’d been earning were the worst to happen. However, this usually isn’t possible early in your financial life. While it is the best long-term option, you can’t be expected to magically have $2,000,000 or more in the early or even middle stages of your career. So, this is a goal, but not an immediate solution.
2. Having an emergency fund. For a short-term emergency, you need enough cash on hand to bridge the income gap. Typically, this kind of fund can hold you over for 3-6 months. However, we are talking about long-term emergencies today.
3. Having disability insurance. You need coverage for a long-term stop in work, especially early in your career. When you’ve worked at a large company, it may have been provided, but when you’re on your own, it’s your responsibility to provide your own insurance. Disability Insurance will pay you in the event that you are unable to work.
   

Options 1 & 2 are vital to any plan, but relatively straightforward. Disability Insurance can be hard to understand so we go into detail on Option 3 and what it all involves below.

How Disability Insurance Works

As its name implies, disability is a type of health insurance designed to replace your income in the event that you cannot work. Here is an example of how an average disability policy functions: You are unable to work, your policy kicks in, and you begin to receive a payment from the insurance company.

Sorry, I’m just kidding. If only it was that simple and I could end the blog here!

How Do I Qualify for a Claim?

You can make a claim on your disability insurance when you are unable to complete the usual duties of your occupation and you see a reduction in income. From there, the question becomes “How is occupation/disability defined?”

There are two major tiers to disability definitions.

1. Own Occupation. This means that you would receive benefits if you could no longer perform the duties of your current occupation, even if you are able to work in other occupations.
2. Any Occupation. In contrast, an any occupation rider will only be paid if you cannot work any job “that you are reasonably qualified for by job experience/education.”
   

What does this mean? In a nutshell, an own occupation definition is preferable because it only reflects on your ability to do your current job. In other words, there is a higher likelihood that you will qualify as no other jobs are considered.

That can help, since you don’t want to become disabled and then have the insurance company say, “Well, actually we think you can go get work doing another job.” When looking at definitions, some companies will also include a feature that allows you to continue working while receiving benefits for the job you are disabled from. Meanwhile, others will not.

This changes company by company, so make sure to read the fine print.

The next way that you can qualify is through a partial disability clause. This allows you to make a claim if you only see a reduction in earnings; not a full and total disability. For example, if you were unable to work a full five days a week and your earnings decreased by 50%, you would qualify for 50% of your disability benefit.

If it was me, I would be looking for 3 things:

1. An own occupation benefit.
2. A benefit that will still pay me if I change careers, post-disability.
3. A partial disability clause.
   

How Much Does Disability Insurance Pay?

Now that you’re qualified, the next thing to find out is how much the policy will pay. Typically, a disability policy will pay a maximum of 60-70% of your total income. However, this can be dialed into your personal needs.

While at first glance, it may seem like you are taking a substantial pay cut, disability benefits can be tax-free, if they’re structured properly. If you are in the top marginal tax bracket, your after-tax income will be about the same or higher.

The example below illustrates a single business owner earning $500,000 in an LLC in the State of Georgia.

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As you can see, the 60% benefit is close to total replacement of your income, once the tax-free nature of the benefits is taken into account. And then comes my favorite question (and I know it’s yours too): “Can I deduct that?”

The short answer is “Yes” and you may be tempted to do exactly that. However, if you write off your disability premiums, your benefits will become taxable in most cases. Deciding not to write off your premiums is what keeps the benefits tax-free.

This means that rather than breaking even on a 60% benefit, you would probably only replace about 40% of your income. Put another way, you may forgo a few thousand dollars a year in deductions now for potentially hundreds of thousands of dollars in tax-free income later.

In my mind, that is a trade I am willing to make to insure against a worst-case scenario properly. A properly-designed disability insurance policy can truly cover some of the worst-case scenarios.

How Long Does Disability Insurance Last?

The next question that I often hear is “How long will the insurance last?”

There are two main time periods to be aware of in a disability policy: the elimination period and the benefit period.

• The Elimination Period. This is the waiting period for a disability policy aka how long it will take before you receive the benefits? It can range from 0 days for a short-term policy up to two years (for some long-term policies). However, the average waiting period is 90 days for a long-term disability policy.
• The Benefit Period. This refers to how long your policy will pay. It depends on a host of factors (mainly your health), but the maximum is typically age 67 or your Social Security Full Retirement Age.
  

These policies are designed to last all the way to a typical retirement. Nevertheless, the reality is that they can last as long as you need them to, unless you have some qualifying circumstances. For example, if you apply after age 65, you may not be able to get a long benefit period.

In summary, you should insure yourself for the term that will allow you to meet your goals, whether that means retiring at 65 or reaching financial freedom at 55.

How Much Does Disability Coverage Cost?

The next question is, typically, “Okay, this sounds good, but how much is it?”

Disability Insurance Premiums are based on your health, age, gender, and occupation. The payout condition is also three times more likely than death, so the premiums reflect that (and will typically be higher than a life insurance policy). Let’s look at the details:

• Age. These premiums typically cost less the younger you are. One interesting exception is that a policy in your mid-50s may be more than in your mid-60s. This is because there are potentially more years of benefits to pay.
• Benefit Period. This refers to how long the coverage lasts. A 5-year benefit is typically less expensive than one lasting to Age 67.
• Health. The more health conditions you have, the higher your premium is likely to be.
• Gender. Women’s premiums are typically higher than men’s (unlike with life insurance, where the opposite is true).
• Occupation. A riskier job, such as a lineman, carries a higher premium than a lawyer or engineer.
• Income. Higher-income jobs typically have higher total rates, but a lower cost per benefit
  

As you can see, this is a moving target, so please don’t take any of these as quotes. Generally speaking, I would expect to see your premiums in the range of 1-3% of total income.

Finally, you may be wondering if premiums in disability policies can increase as you age. There are two main types of disability policies: non cancelable and guaranteed renewable.

• In a non cancelable policy, the company cannot cancel your policy and cannot raise premiums.
• In a guaranteed renewable policy, they cannot cancel your policy, but they can raise premiums on everyone who is in your rate class; just not you individually.
  

Put simply, noncancelable is the superior option.

Other Considerations

While we have discussed definitions, premium stability, and benefit periods, as a business owner, you may have additional options—if, for instance, you cannot qualify due to your health. How is that possible?

If you are unable to qualify for a policy, you may be able to qualify using a group policy owned by your company. However, there are a few catches:

1. You must have at least one more employee to join you.
2. You may need to pay for the employee’s coverage.
3. The definitions of a group policy may not be as friendly as an individual policy. For example, you may only have two years of your own occupation coverage rather than the full benefit from your own occupation until age 65.
4. Finally, remember that the premiums in a group policy will increase over time.
   

You may be able to find an option, even if you have struggled to in the past.

Finally, the last item I wanted to share on this blog was an example of how a disability can affect a financial plan. I have this article in video form and at the end of the video, you can see two plans: one with a disability policy and one without a disability policy.

As you can see, the trade-off between having coverage and not is substantial in the event that the worst comes to pass.

Summary

Disability Insurance is a dense, complex topic but is a true lifesaver in the event of a catastrophic event. Making sure you know what you are purchasing is extremely important so that your long-term financial plan isn’t derailed by unforeseen events.

If you’re unable to be self-insured, I’d say the keys to protecting your income successfully are:

1. Having an own occupation definition of disability.
2. Having partial disability clauses.
3. Having noncancelable premiums.
4. And having a benefit period that is sufficient to insure your plan.
   

I hope that this has helped you understand disability insurance. Ironclad Wealth Management can help you sort these things out. If you have any questions, please feel free to contact me at pgmoore@ironcladwm.com.

If Patrick Can't Save Your Business $5,000 in Taxes, You Get Your Money Back

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