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Even if you have disability insurance to protect you in the event of a disability, how will your disability insurance protect you when you reach retirement age? How much will your retirement plan's accumulation suffer as a result of the loss of contributions and employer matching? Are you confident that Social Security will be able to fill in the gap?
Millions of individuals today have long-term disability insurance through their employment or they own individual disability income policies. Many understand that the risk of becoming disabled is greater than dying during their working career. This is obviously why disability insurance is so important.
What few individuals realize, however, is the dramatic if not devastating impact a disability could have upon their retirement planning and nearly all disability insurance policies do not offer any protection in this area.
The use of 401(k) plans and other defined contribution plans is enormously popular in the United States today.
In 2005, elective deferral limit for 401(k) plans is $14,000. In addition, many employers make matching contributions to those employees participating in 401(k) plans. There are other forms of defined contribution plans that are also quite popular.
A very well understood principle of planning is that the tax-deferred compounding over long periods of time can allow these retirement plans to build very large balances, sometimes well into the millions of dollars. A second principle is that dollars that are contributed into a retirement plan early have more value than dollars contributed into a retirement plan later. This is simply because the earlier contributions have more time to experience tax-deferred compounding. So where does disability insurance come into play?
What happens to those elective deferrals in the event of a disability and how will disability insurance help this problem? At this time, there are few, if any group LTD (long-term disability insurance) plans that address or make up for the loss of those contributions into a 401(k) or to other defined contribution retirement plans.
For example, suppose David, a 34-year-old chemical engineer earning $150,000 a year contributes $14,000 a year to his 401(k) and his employer matches dollar for dollar for up to 3 percent of his pay. This means that the total contribution in 2005 would be $18,500. In addition, David's group long-term disability insurance plan offers him 70 percent of his salary in the event of a long-term disability with a maximum of $10,000 per month. This disability insurance plan provides him with $8,750 per month in the event of a long-term disability which would be income taxable as his employer pays the premium for his disability insurance.
At the beginning of 2005, David was in a severe automobile accident. As a result, he was totally disabled for the entire year. He suffered numerous injuries including spinal injuries that did not paralyze but made getting around very difficult. At the end of 2005, David's doctors told him that he can work part-time at a local college but he might not ever be able to work again as a full-time engineer. David's long-term disability insurance coverage paid him $8750 a month in 2005 after his 90 day elimination (waiting) period.
David was unable to continue his elective deferrals in 2005. His long term disability insurance did not provide additional benefits for this loss. In other words, $18,500 was not deposited into his 401(k). This $18,500 would have 31 years to grow on a tax-deferred basis. The power of tax-deferred compounding over such a long period of time is enormous. If that $18,500 had averaged 10 percent over 31 year period, it would have grown to about $355,000. In contrast, had David been 54 years old when the accident occurred, the $18,500 averaging 10 percent over an 11 year period would have only grown to about $52,000. This is still a lot of money but nothing compared to $355,000. Of course, in David's case, the loss of contributions did not stop in the year 2005.
Because David could not go back to work as a chemical engineer, there were no subsequent year 401(k) contributions made. Several problems became evident from David's group long-term disability insurance plan. The first problem was that his group disability insurance policy only offered an "own occupation" definition of total disability for five years. As long as he was teaching part-time and unable to work in his own occupation, his group long-term disability insurance plan paid him his benefit in full for five years. At the end of five years, the benefit ended. His group long term disability insurance plan offers him some residual benefits for another year but then they stopped.
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