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What is Disability Insurance?

You can get disability insurance from five basic sources: your employer, Social Security, workers compensation, the state, and on your own through an insurer.

Keep in mind that workers compensation takes effect only for an on-the-job injury or illness — and most disabling injuries do not occur on the job. To meet Social Security's stringent disability requirements, you must be unable to perform any job duties at all. And the benefits you'd get from Social Security are rather minuscule.

Large employers will often offer disability coverage at substantially reduced rates as part of their benefits package, but the disability payments might not go very far. A standard long-term group disability plan replaces only 60 percent of your income, up to $5,000 a month.

"Key people probably cannot meet their needs through the group plan alone," says Stuart Shaw, second vice president of group disability with The Guardian Life Insurance Co. of America in New York City.

In addition, if your employer pays your premiums, or if you pay it yourself with pre-tax dollars, you'll have to pay income tax on any disability benefits you receive — at a time when you'll be less likely to be able to spare the money. And the coverage is not portable, meaning that if you buy a policy through your employer, it doesn't go with you when you change jobs. That's exactly why more Americans are purchasing individual disability insurance policies, either as a supplement to coverage through work or because their jobs don't offer it at all.

In general, Social Security disability benefits are not taxable. However, if you receive income from another source, you may have to pay taxed on your Social Security disability benefits.

Options for individual disability insurance

There are a variety of coverage options available. You can buy a policy that pays out benefits for a few months or your entire lifetime. The number of months it takes for you to "qualify" for disability benefits can also vary. On top of that, there is the "definition" of your disability.

Traditionally, insurance companies primarily offered what was known as "own-occupation coverage." Under that policy, you receive benefits if you are unable to work at the specific type of job you were in when you became disabled. A neurosurgeon, for instance, would be compensated if she were unable to perform neurosurgery, regardless of whether she could work as a general practitioner instead.

But because that kind of policy is expensive and discourages people from returning to some type of work, insurers now offer more restrictive plans. One of these is known as a "modified occupation" or "reasonable occupation" policy. This kind of policy pays benefits only if you can't work at a job that is consistent with your education, training, and experience.

Still, even if you can return to work in your field, you might be earning less money. That's where a "residual benefits" or "replacement income" provision kicks in. Residual benefits are designed to protect against income loss, not increase income. A person could receive benefits up to 60 percent of the amount they had been earning before becoming disabled. Earnings determine the amount of benefits.

Consider the doctor who was earning $100,000 as a neurosurgeon, for instance. If the neurosurgeon makes only $40,000 in her new job as a general practitioner, she would be able to receive $60,000 in benefits to make up for the lost income. If she were earning $60,000 as a general practitioner, her benefits would be $40,000 — again, for a total of $100,000.

However, she could not receive so much in benefits that it would push her over the 60 percent limit. That is, if she were only earning $20,000 in her new position, she would not receive $80,000 in benefits.

How long these benefits last and the circumstances under which you can collect are determined by the specifics of your policy.

The lowest-cost premiums are for "any occupation" coverage. Under that kind of policy, you are considered disabled only if you cannot work at any job at all — much like Social Security's definition of disabled. It's the cheapest coverage because you are less likely to become 100 percent disabled. Hence, the policy is less likely to pay out.

Besides those broad categories, you also have a variety of other coverage details to choose among. Some policies have built-in flexibility that changes through the years along with your income. One feature, for example, bumps up your monthly benefit annually. Others offer cost-of-living adjustments. That might be beneficial if you are stricken with a longer-term disability, where inflation can erode the buying power of your benefits over time.

What it costs

How much your premiums cost will, of course, depend on the type of coverage you want — and the type of person you are and what you do on the job.

Consider these two typical examples:

A healthy, 40-year-old female executive who makes $100,000 a year would pay $2,530 in premiums annually for a guaranteed renewable policy that kicks in after 90 days of disability, with a standard policy from UNUM Corp.

Sixty percent of her salary would be replaced if she were forced to work at a lesser job in her field. (Women will generally pay more than men because insurance companies say they file more claims.) However, if she teams up with two colleagues on a plan, gender is no longer considered, and her premiums would be offered at a unisex rate of $1,373 annually.

A 45-year-old man who smokes and earns $80,000 as a plant manager can get the same policy for $2,473. If he didn't smoke, it would be $1,944. He could get a reduced rate of $1,725 if he signs on with at least two colleagues.

Factors influencing cost

If you're in poor health or in what's considered a dangerous or stressful job, your premiums will probably be higher. The longer you want the benefits to last — say until age 65, or even for the length of your life — the more expensive the premiums. If you want to reduce your premiums, consider coverage that lasts only five years. Or delay the amount of time it takes for your benefits to kick in. Instead of the standard 90 days, opt for six months or even a year (if your personal savings can support that). You can even exclude certain injuries or illnesses that could increase your premiums, such as a bad back. One of the best ways to cut costs, as the examples show, is to purchase coverage with several other people.

In addition, many policies now tend to be guaranteed renewable. With a guaranteed renewable policy, the insurance company cannot refuse to renew your policy and it cannot change any of the policy's terms except your premium cost. And if your premium does go up, it must go up for the entire policyholder classification (such as everyone in a certain occupation), not just a few people.