There’s nothing sexy about long-term disability insurance (LTD). 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.
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, especially since LTD doesn’t kick in until after you’ve used up your short-term disability (STD), if needed. 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 with pre-tax dollars, so before taxes are taken out of your salary. The cost typically is a payroll deduction.
- And there’s the post-tax premium , when you pay for coverage with after-tax dollars, which is 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 on disability benefits or when you’re on 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 IRS 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 insurance 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’s group disability insurance plan, 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 benefits in the future, the benefit payments 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 the disability policy could provide should you ever need it for a period of time, 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 disability income at a time when you’re too sick or injured to earn it to cover medical expenses, personal needs, and the everyday costs of living.
4. Will you have a family or others to support you with your disability payments?
The choice between pre-tax and post-tax dollars, 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 and how much of that the benefit amount could cover. 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 or bring in supplemental income?
If you support others, Hall says the post-tax option may be your best choice for disability coverage, 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 LTD insurance coverage 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-paid option and also selects the voluntary post-tax plan, they’ll need to know that they’ll still pay taxes on the long-term disability benefits received from their employer’s primary pre-tax long-term disability 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 LTD plans 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 LTD benefits, 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 (which includes social security and medicare taxes) 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 an insurance 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 insurance company. You’ll be OK.”
What is imputed income, and when is it calculated for LTD?
For tax purposes, the value of the benefits for non-cash compensation is what gets calculated as imputed income, which isn’t included in net pay but is added to gross wages. When LTD premiums are taken pre-tax from paychecks, employers report that for part-time or full-time employees on form W-2.
Imputed income is also calculated from fringe benefits that are non-cash employment incentives. Minimal (aka de minimis) incentives like an occasional meal paid by a company may be considered such a small amount that it wouldn’t be accounted for, but professional tax advice can provide guidance on how this can be interpreted. In addition, while health insurance isn’t considered a fringe benefit, pre-tax health savings account (HSA) contributions up to the limits through a cafeteria plan would fall into that category. Other examples of imputed income include but aren’t limited to:
- Group term life insurance coverage exceeding $50,000
- Gym membership
- Dependent care assistance over tax-free maximum
- Education assistance over tax-free maximum
- Adoption assistance over tax-free maximum
- Benefits for domestic partners
- Commuter or transportation benefits
