Disability Income Insurance FAQs

There are questions surrounding disability income insurance. Life insurance is a big deal in any household. Without it, you’d have to worry about your loved ones. There are many options to choose from when it comes to buying life insurance. Our experts answer some questions revolving around this topic.

Question – What definition of disability does the government use to determine one’s eligibility for disability benefits under Social Security?

Answer – Disability for Social Security purposes is defined as the inability to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a period of at least twelve months or longer. This is a fairly difficult definition to meet because it requires that disabled individuals be so severely disabled that they not only be unable to work at their previous occupations or professions but be unable to engage in any kind of gainful employment at all.

Question – What is the regular care and attendance of a physician requirement?

Answer – Generally, an element of meeting the definition of disability under a disability income policy is that the insured person must be under the care of a qualified physician in order to continue to receive disability income benefit payments.

Question – Are disability income benefit payments subject to FICA and FUTA tax?

Answer – Payments made to disabled employees by either an employer or an insurer are subject to social security tax (FICA) and federal unemployment tax (FUTA) for the first six months after the last month in which the employees worked for their employers. After six months, such payments are exempt from social security and federal unemployment tax. However, if the employees contributed to the plans that pay the benefit payments, the portion of such payments attributable to the employees’ contributions is not subject to social security tax.

Question – Are disability insurance premiums paid with pre- or post-tax dollars?

Answer – Most often, disability plans that require employee contributions be paid with posttax employee dollars. If so, benefit payments are free of any tax liability. Some plans are paid with employees’ pretax dollars through Section 125 plans. By paying premiums with pretax money, the employee’s income is reduced, so they pay fewer taxes. However, this relatively small tax savings could become expensive in the event of disability, since all disability benefits that the employee receives will be taxable. An employee receiving a disability benefit is already dealing with an income level below predisability earnings. Paying taxes on a reduced income adds even more financial pressure on the claimant.

Question – Are disability income benefit payments subject to income tax withholding?

Answer – While the tax laws generally require employers to withhold income tax from disability income benefit payments, the tax rules do not require withholding on benefit payment amounts that the employees can excluded from their income. Further, if an insurance company or other entity under an accident or health plan makes the disability benefit payments, the tax rules require no withholding of income tax.

Question – How is a disability income benefit received under a life insurance policy treated for income tax purposes?

Answer – When policyowners receive disability income benefits under a disability rider attached to a life insurance policy, the tax rules treat the amounts as separate accident or health benefits and not as proceeds from the life insurance policy. Thus, such benefit payments are excludable from income as “amounts received through accident or health ­insurance… for personal injury or sickness.”

Question – What is disability buy-out insurance?

Answer – Disability buy-out insurance is designed to provide coverage funds to buy out the disabled individual’s interest in a business upon the total and permanent disability of a shareholder or partner.

Because of the many factors involved as well as the increased potential for adverse selection and moral hazard, insurers underwrite these policies very tightly and require the businesses and the key employee-owners to meet stringent business, financial, and personal standards before they will permit a business to purchase this type of coverage. For example, insurers typically require a company to have been in business for a certain amount of time, to have consistent profits and revenues, and stable and strong management before they will issue a disability buy-out insurance policy.

Question – Do any insurance companies offer temporary disability insurance?

Answer – The authors are not aware of any companies that offer temporary disability insurance. Upon reflection, at least one reason such insurance plans are rare or nonexistent seems pretty obvious. With health insurance coverage, such as when people are between jobs, or even one-year or other shorter-term life insurance policies (which are typically renewable and convertible into long-term permanent policies), the risks to the insurer can be high, but manageable and predictable, with the potential for temporary buyers to become purchasers of long-term continuing coverage policies.

With a temporary disability plan, the policy would remain in force for only a temporary period, say until the prospective insured’s employer establishes a LTD plan in the coming year. So the insured would be planning to keep the policy in force and pay premiums only for a year or so. However, with disability income insurance the risk generally is extremely long term, because a disability occurring during the temporary, premium-paying period while the policy is in force could involve the insurer having to make benefit payments replacing 50 percent, 60 percent, or more of the insured’s earnings for many years, until the insured reaches age sixty-five, usually. It would be hard for the insurer to even design a plan with low enough premiums to make a temporary plan feasible.

However, a few insurers (Guardian, for example) offer a slightly different product, called a short-term disability program, in most cases involving group disability insurance sponsored by employers. More insurers also offer what is called supplemental disability insurance which is designed to be an additional tier of coverage on top of a primary disability income policy, which the employer usually provides.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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