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    Covering The Overlooked Income Risk

    At the bottom of the list of insurance policies most people consider is disability insurance. It’s the last policy people buy and the first they cut when cash becomes tight. Yet disability insurance is essential for a package of complete protection. At many ages, you’re more likely to need it than other types of insurance. On the other end of the spectrum, there are people who have too much coverage or the wrong coverage for them.

    Disability insurance (DI) provides cash flow to people who are unable to earn income because of physical or mental conditions. DI can be short-term, paying benefits for a limited period, or long-term, paying benefits for many years or until age 65. It’s important for those in physically demanding jobs, because they’re most likely to lose their ability to earn income due to injuries or chronic conditions. But DI also covers disabilities that don’t spring from work. Your ability to earn income could be diminished by an auto accident or an accident while working around the home or even from falling. DI also kicks in when you are limited by a stroke, heart condition, other physical condition, or a nervous or mental disorder. As I said, statistically at many pre-retirement ages you’re more likely to suffer one of these accidents or injuries than you are to die. DI is more likely to pay benefits than life insurance.

    Group DI policies, offered by most employers of any size, are the foundation of disability protection plans. Under the typical plan, the employer pays for basic coverage; and there’s an option for employees to obtain additional coverage by paying the additional premiums. A typical basic group benefit pays 60 percent of salary per month for a period of years. You might be able to pay additional premiums to increase the percentage of salary or the period covered. Coverage purchased through an employer’s group plan is likely to be substantially less expensive than an individual policy.

    When employer coverage isn’t available or isn’t adequate, consider an individual DI policy. An advantage to individual DI is you keep the coverage when you change employers, and you don’t have to medically re-qualify when you change jobs.

    Individual DI policies come in two types. Guaranteed renewable policies allow the insurer to increase the premiums only on a class of policyholders, but you won’t be denied renewal because of your health or other conditions. Non-cancellable policies have fixed premiums as long as the premiums are paid on time. Most advisers prefer non-cancellable policies, because you’re sure of the policy and its cost for the long term. But the initial premiums are substantially higher. In late 2011, for example, LIMRA, an insurance information service, said the average guaranteed renewable individual policy was $600 annually while non-cancellable premiums were $2,000.

    Before buying a policy, consider the definition of disability that will trigger payment. A standard coverage is “own occupation,” which pays benefits for someone unable to continue his career but able to pursue other work. For example, a surgeon might be unable to operate but be able to teach, consult or treat patients in a non-surgical setting. A policy also might pay something in case of partial disability while others cover only total disability.

    The broader the coverage, the higher the premiums. To keep premiums low, don’t insist on “own occupation” coverage or partial disability riders, known as residual coverage.

    You also can reduce premiums by lengthening the waiting period. DI policies pay only after you’ve been disabled for a minimum time, known as the waiting period. The longer you self-insure for temporary or initial periods of disability, the lower the premiums. Another way to reduce premiums is not to elect the inflation rider.

    The level of coverage also determines premiums. Instead of trying to replace all or most of your current income, you can buy DI that covers your essential expenses. DI also offers a catastrophic benefit rider that pays additional benefits in case of a severe disability. Consider whether you want to pay extra for this rider or if it duplicates coverage available through a long-term care policy or other coverage.

    Residual benefits and inflation coverage are valuable and worthwhile if you can afford them. But if either or both of those provisions make DI unaffordable, it’s better to have some coverage without those riders than to have no coverage.

    It’s important to consider the long-term tax effects of policy choices. The rule is that disability benefits when paid are tax-free if you didn’t receive a tax break on the premiums. If you deducted the premiums or they were tax-free because they were paid by the employer or through an employer plan, then any disability benefits you receive will be included in gross income.

    You’re likely to be better able to handle the taxes when not disabled, so it generally makes sense to forego tax benefits on the premiums and ensure any disability benefits you receive are tax free.

    You’ll want to reassess DI coverage as you near retirement. You might have accumulated enough assets when you are within five years or so of planned retirement that it makes sense to drop the coverage and invest the premiums. But carefully perform your analysis. The last few years of employment often are valuable savings years that can pump up the nest egg. They also are when people are most likely to become disabled. Be sure you have a substantial cushion in your nest egg before dropping DI coverage.

    You likely qualify for disability benefits under Social Security, but these benefits are limited. Social Security pays disability benefits only for total disability. If you can perform any work, you don’t qualify. The disability also must be permanent, which means it has lasted or is expected to last more than one year or result in your death. You also might qualify for workmen’s compensation benefits, but they pay only for a disability incurred as a result of your job.

    — Bob Carlson

    Bob Carlson is editor of the monthly newsletter and web site, Retirement Watch. Carlson is Chairman of the Board of Trustees of the Fairfax County Employees' Retirement System, which has over $3 billion in assets, and was a member of the Board of Trustees of the Virginia Retirement System, which oversaw $42 billion in assets, from 2001-2005. He was appointed to the Virginia Retirement System Deferred Compensation Plans Advisory Committee in 2011. His latest book is Personal Finance for Seniors for Dummies, published by John Wiley & Co. in 2010 (with Eric Tyson). Previous books include Invest Like a Fox... Not Like a Hedgehog, published by John Wiley & Co. in 2007, and The New Rules of Retirement, as published by John Wiley & Co. in the fall of 2004. He has written numerous other books and reports, including Tax Wise Money Strategies, Retirement Tax Guide, How to Slash Your Mutual Fund Taxes, Bob Carlson's Estate Planning Files, and 199 Loopholes That Survived tax Reform. He also has been interviewed by or quoted in numerous publications, including The Wall Street Journal, Reader's Digest, Barron's, AARP Bulletin, Money, Worth, Kiplinger's Personal Finance, the Washington Post, and many others. He has appeared on national television and on a number of radio programs. He is past editor of Tax Wise Money. Carlson is an attorney and passed the CPA Exam. He received his J.D. and an M.S. (Accounting) from the University of Virginia and received his B.S. (Financial Management) from Clemson University. He also is an instrument rated private pilot. He is listed in several recent editions of Who's Who in America and Who's Who in the World.

    | All posts from Bob Carlson

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