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My employer offers long term disability insurance as a standard benefit, and they also give me to option to make it taxable. From what I can tell, this means:

  • The premium is added to my taxable income
  • If I'm actually disabled, I won't have to pay taxes on the benefits

It seems to me that taxing it now is a good deal, since the premiums aren't very expensive (around $200/year seems standard), and the benefits are much more (potential to entirely replace your current income).

This seems like a no-brainer to me, but I can't find any commentary on pros/cons, which makes me uncomfortable. Am I missing anything?

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    Disability insurance never replaces entirely your current income. Payments are usually 60% to 65% of your salary, not close to 100%. Also, pay close attention to JoeTaxpayer's and littleadv's comments: with good luck, you will never collect any disability payments, but will, if you choose to do so, have paid tax on the premiums. – Dilip Sarwate Jun 19 '12 at 0:54
  • You are correct, this risk-taking adventure is commonly referred to as "insurance" You pay a fee to hedge against risk that you might need a benefit. If you never actually require the benefit it would appear as if you had paid money for nothing. But you haven't, you paid to hedge against risk. And by the way, luck is a backwards looking statistic, you can't have luck, good or bad, in the future. – stu Nov 3 '17 at 13:25
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Do some math. Figure out the net (after tax) money you'd have if you left it taxable, then look at the difference. In effect, you'd pay $X (the tax now) for $Y benefit (the tax on the full benefit not paid). The math works similar to you buying a small policy on your own.

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You have to consider that taxes that you pay on the premiums is money definitely paid, while benefits being tax free won't save you a thing if you never receive the benefits.

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Historically the advice was to buy the best policy possible (not cheapest), at the lowest price, with the highest benefit. The cost relative to the benefit is very cheap, and your much more likely to use disability than life insurance (for instance). It is usually cheaper to pay for it with after tax dollars than to buy more insurance.

In theory, you want to buy enough disability to replace 100% of your after tax income -- or more since there is no inflation protection built into most policies. Insurance companies often will not sell this due to moral hazard -- although you may be able to combine policies to reach 80% or so.

Keep in mind that you will need to continue to save / invest if you are on long term disability, since most policies cease payment at 65 or when your eligible for Social Security. In addition, your expenses often rise due to the increased medical expenditures, possibly needing COBRA / private health insurance, etc.

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