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Do you need disability insurance?

Your employer's group plan might not provide the coverage you need

Last reviewed: August 2010

What would happen to your finances if you were unable to work because of an illness or injury? How long would your savings last? Would you have to dip into retirement accounts? How long could you pay your mortgage?

The number of people facing that problem might surprise you. One-third of the people in the U.S. between 35 and 65 will become disabled for more than 90 days, according to the American Council of Life Insurers. One in seven workers will be unable to work for more than five years—a long time to survive without a paycheck. While you might think accidents are the main reason people become disabled, most cases are caused by illnesses. The most likely culprits are arthritis, back problems, and heart disease.

Your employer probably offers short-term disability coverage, also known a sick leave. Those plans can cover just a few days of your pay to as much as a year.

Group plans at work

Your employer might also offer a long-term disability plan, which will kick in when short-term coverage ends. Typically these group plans will pay you about 60 percent of your salary. You can also buy a supplemental plan or individual plan that will cover up to 70 percent or 80 percent of your earnings. (No plan will cover all of your salary; insurers want you to have an incentive to get back to work.) Benefits will continue for a set number of years or until you reach retirement age.

If you have a long-term disability plan at work, find out how much of your salary it will replace, and for how long. About half of mid- to large-sized firms offer benefits that last for at least five years, according to America's Health Insurance Plans, an industry group. The amount you receive each month might be less than the typical 60 percent because most group plans set limits on the total amount they will pay. Bonus income will probably not be covered. And your benefits will be reduced by the amount of any workers' compensation, Social Security disability, or lawsuit payments you receive.

In addition, workplace plans are governed by the federal Employee Retirement Income Security Act (ERISA). "Because it falls under federal jurisdiction, states may be unable to help workers whose disability claims are denied, and group claim disputes are handled by arbitration, not by the courts," says Frank Darras, a disability insurance attorney with Shernoff Bidart & Darras in Claremont, Calif. And of course, your group plan is not portable. If you leave your job, you lose your coverage.

Although group plans have lower premiums than individual policies, you'll have to pay income tax on your benefits if your employer pays those premiums. Benefits are only tax-free if you pay the premiums yourself. "I suggest my clients see if they can pay their own premiums and get a 1099 to prove it," says Peter Katt, a fee-only life insurance adviser in Mattawan, Mich. "If you can arrange it, it's better to take a premium hit when you're working than to pay taxes when you're out of work."

Buying coverage on your own

If you want to buy your own disability coverage (or supplement a workplace plan) you can get it through some financial planners or life insurance agents. But as you might expect, it can be costly. Prices will vary based on several factors, including your age, gender, health history, and occupation.

If you're under 55 you can expect your annual premium to equal 1 to 3 percent of your yearly income, says Jane Nobiletti, an insurance brokerage consultant with the Agent Support Group in New York City. If you are over 55, you might pay 4 percent or more. Adding riders that improve coverage will make it even more expensive.

And there are lots of riders and policy options to consider (see Features to look for). LIMRA, an insurance research and consulting firm, says only long-term-care insurance is more difficult to sell than individual disability plans. "In the last 10 or 15 years, a lot of companies have ceased to offer it," Katt says. "Those that do are more strict about who qualifies and the benefits they can get."

Before you buy you'll also want to make sure the insurer has the top financial strength rating from TheStreet.com, the insurance rating firm we've found has the most conservative grading system. It receives no compensation from the companies whose products it rates.

This article appeared in Consumer Reports Money Adviser.

Posted: August 2010 — Consumer Reports Money Adviser issue: August 2010