Don't Wait Until It's Too Late to Get Disability Coverage

Marshall Rathmell |

Most experts suggest carrying enough disability insurance to replace 60-65% of your gross earnings with non-taxable benefits.  The reasoning behind this suggestion is that the other 35% of income you're not replacing equals the estimated amount of taxes that are withdrawn from your paycheck, savings you needed to do while working and other expenses that would go away if you weren’t in the workforce. 

So, if you're disabled, you would ideally have your disability benefits equal the net amount you would need to continue your lifestyle.  That’s how it’s supposed to work, but there are some common pitfalls that can have damaging consequences for your finances if you aren’t careful to avoid them. 


There are three big issues to watch out for when you’re evaluating employer-provided disability insurance. 


Potential tax liability.


Almost all employer-provided disability plans are paid for using funds the employer deducts as expenses.  That means they don’t pay taxes on the amount of the premiums paid, and any benefits you receive are taxable as income.  If you claim disability under these circumstances, you will be liable for paying taxes on the amount of your benefits payments.  Even if your employer provides enough disability coverage to replace 60% of your wages, you will walk away with substantially less than 60% after taxes.


Whether your income exceeds the cap.


If your income exceeds your policy’s income cap, your benefits won’t cover 60% of your wages, even if you max out your benefits.  Add this problem to any tax liability as discussed above, and the gap between the amount of money you need and how much you actually get is even greater.

Whether part of your pay is commissions.


Most employer-provided disability benefits are calculated only on your base salary.  If you make substantial commissions which you depend on to live, your employer-provided benefits may not cover those funds.  For example, say your base salary is $100,000 a year, but you consistently earn $80,000 in commissions and you live a $180,000 lifestyle.  If you become disabled, your benefits will be calculated on only $100,000, leaving an $80,000 income gap.


There are a couple of simple strategies you may be able to use to solve these issues.


First, get a supplemental policy you pay for out-of-pocket to make up for the shortfall in your employer-provided policy.  The premiums are generally modest and are well worth the extra coverage it would take to pay the taxes you would owe on your employer-provided benefits.

Second, ask your employer to allow to you accept the premiums as income on your W-2.  Many employers offer this option automatically.  In this case, they would add the amount of your premiums to your pay and withhold taxes on it as income.  Then if you become disabled, the benefits you received would be non-taxable since you would already have paid taxes on it.


Disability insurance is a critical component to any sound financial plan.  Having sufficient coverage can mean the difference between being free to focus on recovering if you become disabled or having to worry about how you will pay your bills.  Consult your financial advisor if you have any concerns about whether your policy is adequate.