There’s nothing sexy about long-term disability insurance. Few relish paying for the coverage, which provides an income when a person can no longer work because of illness or, in most cases, non-work-related injury. And nobody wants to have to use it because that would mean they’re dealing with a devastating disease or serious impairment.
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But here’s why we all need to think about it: There is a better chance you’ll face disability than death during your career.
“You are three times more likely to experience a disability than to die before the age of 65,” says Steven L. Crawford, president of DisabilityQuotes.com. “With advanced medical technology, things that used to kill us no longer do, but it doesn’t mean you’re healthy.”
While you may never use it, long-term disability insurance ensures you’ll still be able to support yourself in the event of an illness, injury, or accident. But what’s the best and most affordable way to get it, you ask?
It comes down to two options, and they’re based on the way you pay for your disability insurance premiums:
- There’s the pre-tax option, when you pay for the premium before taxes are taken out of your salary. The cost typically is deducted directly from your paycheck.
- And there’s the post-tax premium, when you pay for coverage with your take-home pay after taxes have been pulled from your earnings.
5 questions to help you choose
Which option to choose will depend on some variables. If you’re contemplating the best way to pay for your long-term disability insurance premiums, here are five questions to ask yourself.
1. Would you rather pay taxes now or when you’re on disability leave?
Your answer to this question might be neither, but that’s sadly not an option. You’ll have to fork over some money to the government at some point. But when?
If you choose the pre-tax option and then need to go on disability leave, you’ll have to pay taxes on your disability insurance payout. Those payouts generally cover between 50 and 80 percent of your salary.
If you choose the post-tax option, you paid taxes before you paid for the premium. That means you won’t have to pay taxes on the benefits you receive if you were to incur a disability.
In almost every case, Rob Drury, executive director of the Association of Christian Financial Advisors, recommends the post-tax option when available.
“This makes the benefit tax-free, accomplishing two things: It lowers or possibly eliminates one’s tax obligation during a period of disability when finances might be tight. And it effectively increases one’s income during the disability period as the benefit income is not taxed,” Drury says.
2. Are you living paycheck to paycheck?
If how much income you take home now—not later—is a priority, pre-tax contributions might be the best choice, says Allan Hall, president of the Northern California Employee Benefits Council and assistant vice president at Heffernan Insurance Brokers.
“Pre-tax contributions will be cheaper while also lowering the taxable income and, thus, end-of-year taxes for the individual,” Hall says. “You’re being taxed on a lower gross income.”
If you choose the pre-tax option through your employer, you avoid your half of the Federal Insurance Contributions Act (FICA) tax on that amount and a higher federal income tax payment, which ranges between 10 and 37 percent of what you make, according to Kevin Haney of A.S.K. Benefit Solutions. Depending on where you live, you could also save on state income taxes.
So if those extra dollars are critical to your daily life, pre-tax premiums might be the option for you. Just remember, if you do claim disability in the future, those benefits will be subject to taxes.
3. Is your primary focus the benefit, not your contribution?
If you’re less concerned with your take-home pay, but more concerned with the actual benefit should you ever need it, post-tax contributions will likely make more sense, says Hall. This is because the payout when a claim is filed is not taxed. So you’ll enjoy more money through the benefit at a time when you’re too sick or injured to earn it.
4. Will you have a family or others to support you with your disability payments?
The choice between pre-tax and post-tax, says Hall, really comes down to what a person’s priorities are. To make the decision, you’ll need to think about your own future needs. If you become ill or injured and can’t work, who else would be affected?
Who relies on the income that you bring home each month? Just you? Or do you have a partner, kids, and other family members or loved ones who rely on your paycheck?
If you support others, Hall says the post-tax option may be the best choice for you because you won’t have to pay taxes on your benefit.
“Considering that you’re only going to get about two-thirds of your paycheck, you wouldn’t want to get taxed another 30 or 40 percent on top of that,” Hall says. Adding taxes on top of an already decreased income could drop your spending money significantly, and that could severely restrict your lifestyle.
“If you have people depending on you, all that money becomes very important when you are disabled,” he says.
5. Does your employer offer both pre-tax and post-tax options?
Some employers provide long-term disability insurance to their employees in two ways—through a pre-tax option with premiums deducted from paychecks and a post-tax premium plan that workers can opt into. If an employee takes advantage of their employer’s pre-tax option and also selects the voluntary post-tax plan, they’ll need to know that they’ll still pay taxes on the benefits received from their employer’s primary pre-tax plan—because that premium was paid before taxes were taken out of their paycheck.
“The benefit for each one would be taxed differently,” Hall says.
3 reasons why small businesses owners opt for pre-tax disability insurance premiums
Just 21 percent of small business employees have access to long-term disability insurance through their employers, according to the US Bureau of Labor Statistics. But it’s a benefit small business owners should consider.
In the competition for qualified workers, the perk can help businesses win over job candidates who would opt for a career at a bigger company with a more robust benefits package.
And when employers offer long-term disability insurance, they typically choose the pre-tax option for three reasons, Haney says.
- It’s easier to administer. “Employees can only make changes—buying or canceling coverage—during the annual open enrollment or during an initial open enrollment for new employees,” Haney says. “This allows business owners to focus on running their business during the remaining 11 months of the year.”
- It typically leads to higher participation rates because employees avoid some FICA tax and enjoy savings on federal—and potentially state—income taxes. And many insurance carriers, says Haney, have participation minimums, so employers need to ensure those numbers stay high.
- It comes with an all-important tax benefit. Because the premiums are pulled from paychecks before taxes are withheld, employers get an immediate payroll tax reduction. Small business owners also avoid paying FICA taxes on the pre-tax premiums as they don’t count toward their reportable income, Haney says.
Your employer and financial advisor can help you decide the best course of action based on your own income level and needs. But, says Crawford, don’t get so caught up in every detail that you never make a decision. It’s better to have a policy in place than to quibble so long over which one to get that you don’t have one when you need it, he says.
“I have seen a lot of people overanalyze, read way too much, get caught up in what policy should I get and how much,” he says. “The best policy is the one that’s already in force when you need it… Pick something. Go with a reputable company. You’ll be OK.”