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How Much Disability Insurance Do You Need?

During your working years, your ability to earn income is your greatest asset. If you don't have an adequate source of replacement income, a disability can quickly turn into a financial catastrophe.

Protect yourself by making sure you have enough insurance to cover your needs. Calculate the minimum disability insurance benefits you need by using this formula:

Current Monthly Living Expenses - Reductions in Spending - Income From Other Sources = Minimum Disability Insurance Benefits

Current monthly living expenses
First, determine how much you're spending now.

If you have a current monthly budget, you know how much money you need to maintain your lifestyle and spending habits. (And if you don't live on a budget, now is a great time to start!) Make a list of all your monthly expenses. For occasional or annual expenses, such as gifts for the holidays, calculate your annual expenses and divide by 12. Don't forget to add a miscellaneous or "life happens" category. Look through old receipts and bank withdrawals to make sure your budget is accurate and complete.

Another way to determine how much money you and your family go through in a month is by looking at your take-home pay. If it's all gone at the end of the month, that's about how much you spend. If you're putting money into savings and investments, you're spending that much less. Think of this method as a reverse budget -- you take your current cash outflow and work backward to your monthly living expenses.

Reductions in spending
Next, determine how much less you might spend if you weren't working.

You generally don't need the same level of income when you are disabled as you did when you were working. In fact, you can typically only purchase disability insurance for about 60% of your predisability income.

Consider the following reductions in spending that you could make if you became disabled:

  • Commuting expenses. If you drive to work, you can probably assume it costs you $0.50 per mile.
  • Workday lunches and breaks. If you eat out every day and buy the occasional latte, you could easily save $10 to $30 per day when you are not working.
  • Work clothes. Being unable to go to work can save thousands of dollars per year in clothing expenses.
  • Discontinued activities. It's sad, but life on disability may not include the vacations you're used to. On the bright side, you'll have fewer expenses. You may even generate income from selling those jet skis, ATVs, and other toys.
  • Downsizing. Most of us can make cuts in our budget if we have to. Moving to a smaller, perhaps one-story house may even be a good idea.

Income from other sources
The following items may reduce the amount of disability insurance you need to purchase:

  • Income from savings and investments. This includes interest and dividends, capital gains, rent income, and other sources of income.
  • Other disability income. You may qualify for more than one type of disability payment if you become disabled.
  • Increased income from spouse or partner's work. If you share finances with someone, such as your spouse, you may have a plan that if one of you becomes disabled, the other picks up the slack. This is most practical if you both have the capacity to make a living, but one is working less than full-time now.

In most cases, couples should buy disability insurance for both working spouses. If you're dependent on two incomes, it only makes sense. If one of you becomes sick or is injured, the other may prefer to take care of the disabled spouse rather than immediately return to work. And if something happens to the relationship, dependency on a spouse's income only makes it worse.

Example
Let's take Lisa -- age 45 and single -- as an example for calculating disability insurance needs. Lisa brings home $5,000 per month after taxes and other deductions.

Lisa's budget shows that she needs $4,500 per month to live. She regularly puts $500 per month into savings, so that checks out as a realistic number. ($5,000 take-home pay - $500 actual savings = $4,500 budgeted expenses.)

If Lisa became disabled, she thinks she could save $1,000 in monthly expenses by not commuting or eating out for lunch, without too severely cutting costs otherwise.

Lisa isn't married, so she can't rely on a spouse to support her if she can't work. But she earns dividends and interest of about $500 per month.

Lisa's minimum disability benefit can be calculated as follows:

  •     Current monthly expenses: $4,500
  •     Reduction in spending: $1,000
  •     Income from other sources: -$500
  •     Minimum monthly disability benefit: $3,000

Disability insurance is great -- but only if you have enough of it. It's worth the time you spend to determine whether you have enough disability insurance benefits and to recalculate the amount you need every few years or when your income needs change.

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Sally Herigstad
Herigstad

Sally is a new Fool contributor for 2014, but a long-time personal finance writer, columnist, and certified public accountant. Sally wrote "Help! I Can't Pay My Bills" for St. Martin's Griffin.

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