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Covering the Disability Income Gap

Employer group disability income plans offer tremendous tax advantages to both employer and employee. The employer can deduct premiums as a business expense, and they do not count toward the employee’s taxable income. However, group disability plans usually do not provide enough coverage for upper management and highly compensated employees. Here’s how to provide for these employees’ additional coverage needs. 

The basic group disability income policy acts as a safety net for your employees when a disability keeps them out of work. A basic policy probably provides enough coverage for rank-and-file employees, but its structure can create a major coverage gap for higher-income employees. 

Most group policies replace 50 to 60 percent of pre-disability income—enough to help cover basic expenses while out of work, but not enough to create a disincentive to returning to work. In addition, policies have a maximum monthly benefit. Depending on the insurer, your industry, location and the size of your group, that maximum could be as low as $3,000 or $4,000 for smaller groups, and range from $7,000 to $15,000 for larger groups. If you have executives, salespeople and others earning more than $300,000 per year, this level of basic group plan won’t even replace 60 percent of their pre-disability earnings. 

The policy’s definition of earnings could create another stumbling block to adequate income replacement. Most group policies pay a benefit equal to a percentage of the employee’s “basic monthly earnings.” This usually includes gross salary but may exclude commissions and bonuses. For salespeople and executives with significant commission and bonus income, this could result in a serious income shortfall in the event of a disability.  

To remedy this problem, a number of insurers have developed supplemental group disability plans, popularly known as disability buy-ups. These plans allow highly compensated employees to combine the employer’s basic group coverage with another plan to receive a higher monthly benefit in event of disability. 

You can structure a buy-up plan in several ways: 

Employer-paid plans: In an employer-paid plan, the employer pays all premiums, which it can deduct as an ordinary business expense. Premiums do not count toward the employee’s taxable income, but he/she will have to pay income tax on any benefits received.

An executive buy-up plan often involves two tiers of coverage: a guaranteed issue policy and a modified guaranteed issue policy. If your group of highly compensated employees is large enough, your insurer might be willing to write a guaranteed issue policy, which means the insurer asks no medical questions and provides a group policy at standard rates. This ensures that even executives with health problems will be able to obtain coverage. 

For the second tier of coverage, a modified guaranteed issue plan, the insurer will ask some simple medical questions to make its coverage decision. It may decline to cover an individual, exclude coverage for a pre-existing condition or charge extra premium.  

In some buy-up plans, the employer “carves out” coverage for highly compensated employees, providing them with the basic group plan and then supplementing it with individual disability income policies. Insurers typically individually underwrite individual disability income plans, but may make individual policies available on a guaranteed-issue basis for larger groups. Individual plans also offer better rate guarantees and portability than group policies. Unlike with employee-paid individual policies, however, any benefits received under an employer-paid policy will be taxable income.  

Employer-sponsored (voluntary) plan: The most popular approach to supplemental disability coverage, voluntary plans, require the employer merely to act as plan sponsor, allowing the insurer to directly solicit employees. Employees who elect coverage pay 100 percent of premium. If the employer has a Section 125 (cafeteria) plan, employees can pay premiums with pre-tax dollars; any benefits received will be taxable. Employees can also opt to pay premiums with after-tax dollars and receive policy benefits tax-free. 

Hybrid plan: In a hybrid plan, the employer pays premiums on supplemental coverage for a select group of employees. Employers can deduct premiums as a business expense, but covered employees must pay income taxes on benefits. Other employees can buy the supplemental coverage on a voluntary basis. 

Gross-up plans for key employees: For higher-paid key employees, having the employer pay the premiums makes any benefits received taxable. Since it may be difficult to get an insurer to replace enough of the highly compensated employee’s pre-disability pay, this employee would not want to lose benefits to taxes. To avoid this, the employer can gross-up the employee’s pay by the amount of the premium, and have the employee pay the premium with after-tax dollars, making the benefits tax-free. In this arrangement, the employee pays the tax only on the amount of the pay increase, and receives any benefits tax-free. 

Negotiating Buy-Up Benefits 

To start your search for a buy-up plan, first determine the number of highly compensated employees you want it to cover. The size of the eligible group (both number and percentage of eligible employees), along with plan features, will affect your costs. If your benefits budget can handle an employer-paid or hybrid plan, you will reward your highly compensated employees and help guarantee their financial health. If you cannot commit to an employer-paid plan, a voluntary plan could still give highly compensated employees a valuable benefit by giving them access to a guaranteed issue or modified issue plan with the convenience of payroll deduction payments. 

For more assistance in structuring a disability income plan to fit the needs of all your employees, please contact us. 

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