You know the basics: long-term disability insurance can act as a form of income replacement if you experience a disability that stops you from working. (If you don’t know the basics, check out our comprehensive explanation of how long-term disability works and meet up with us in a few minutes.) But what does that term income replacement really mean? Will long-term disability really replace your full paycheck every month?
Luckily, you can control exactly what your benefit amount — the amount your long-term disability policy would pay out every month — amounts to. When you’re shopping for a policy, you can specify what you want your benefit amount to be. While you can’t go crazy and request a million dollars per month, you can request almost your full take-home paycheck.
How to calculate ideal benefits amount
While you can request up to 60% of your gross monthly income as a benefit amount, it can be prohibitively expensive for some shoppers. You may also not need all of that money. Before you start shopping for a long-term disability policy, it’s worth taking a look at your budget to figure out exactly how much you would need every month if you lost your job due to a disability. Here are a few things to keep in mind when calculating your ideal benefit amount:
Cover your fixed expenses
Mortgages, electricity, internet, food, etc. There are certain fixed expenses that you pretty much know you need to cover every month. It’s hard to say exactly how much of your income you use on fixed expenses — it’s different for everyone, obviously — but if you haven’t already, you should figure out this number, give or take a few hundred bucks. Use this as your baseline benefit amount that any LTD policy needs to meet.
Try to include some discretionary expenses
Books, movies, music, and other types of entertainment are typically not covered by your fixed expenses, but you’re not going to just stop consuming them because you’re using disability benefits. Same goes for other small luxuries, like eating out.
Factor in possible disability-related costs
Your health insurance will probably cover most of your care, but what if you need to improve your home to include an access ramp for a wheelchair? That’s just one example of a disability-related cost that wouldn’t be covered by health insurance and that you would need to pay for out of your own pocket.
Don't forget retirement savings
Most disabilities aren’t permanent — in fact, the average disability lasts less than five years. There’s a good chance that you’ll end up back at work! However, during that five year period, what will happen to your 401(k), IRA, or other retirement accounts? If you don’t build in some amount of retirement savings into your monthly benefit, you may experience a huge setback in your retirement plan.
What does this add up to?
While your ideal benefit amount will depend on your individual budget and your income, we can give you a general range that you can aim for. Typically, we would consider a benefit amount that’s anywhere between 50 and 60% of your pre-tax monthly gross to be a large benefit. If your ideal benefit amount comes out to just under your take-home pay right now, you’re probably in the right ballpark.
What if I'm shopping for supplemental disability insurance?
If you already have a group long-term disability policy through your job, you may be looking to supplement it with a private long-term disability policy. Hurray! In this case, you should look at the benefit you’re already receiving and see what percentage of your after-tax income it covers. Assuming it doesn’t cover 60% of your income (because if it did, why would you get a supplemental policy?), you should figure out what your private benefit amount would need to be in order to get you, in total, 60% of your income from your two LTD policies.
To put that into a formula:
Group benefit amount [Example: 35% of post-tax income] +
Private benefit amount [Example: 25% of post-tax income] =
Total benefit amount [Example: 60% of post-tax income]
There is one huge wrinkle in this calculation, however: group LTD benefits are taxable. Make sure you factor this into your math.
What if your ideal benefit amount is too expensive?
In some cases, it may be prohibitively expensive — i.e., you can’t afford the monthly or annual premiums — to get your ideal benefit amount. This typically happens if you work in a risky occupation or have had prior health issues.
Luckily, there are some things you can do to help make your long-term disability insurance policy less expensive. For starters, you can try reducing your benefit period. The benefit period is the amount of time you’ll receive benefits. The longest benefit period you can get is up to your retirement age (age 67 or 70, depending on the insurer). But you can save money by reducing this your benefit period to just ten, five, or two years.
There are two big reasons why reducing your benefit period is one of your safer options: 1) if your disability is permanent, you’ll probably qualify for Social Security Disability Insurance (SSDI) benefits from the federal government and 2) most disabilities that are not permanent last less than five years.
You can also try increasing your elimination period. The elimination period is the period of time between when your disability starts and when your insurance company starts paying out benefits. More expensive policies have elimination periods of either thirty or sixty days. You can save a little bit of money by switching to a ninety day elimination period, or save more money by lowering it to one hundred and eighty days.
However, if you don’t have enough emergency savings to cover the six months between when you stop receiving a paycheck and when your insurance policy kicks in, a long elimination period can be disastrous. If you choose this option, make sure you’re covered either by emergency savings or a short-term disability policy.
If neither of these options lowers your premium enough, you’ll need to reduce your monthly benefit amount. This is where your previous calculations come in handy. You know how much you’ll need in order to cover fixed expenses, which is your baseline. Start there, and add discretionary income, disability-related costs, and retirement savings in whatever order you deem most important until you can no longer afford the monthly premiums.
Image: Mark Strozier