Long-term disability income insurance (LTD) can significantly buffer the impact of income loss due to disability by providing benefit payments to replace a percentage of the policyholder’s pre-disability income. Unfortunately, however, these insurance policies do not directly address retirement needs. How LTD affects retirement funds can depend partly on the structure of your retirement savings account, and partly on how you manage long-term disability retirement planning going forward. While you probably know that the terms of your LTD policy structure many of your options while you are receiving disability benefit payments, you may not be as familiar with how the terms of your retirement plan can affect the LTD impact on retirement savings. To effectively balance long-term disability and retirement planning, you will need to conduct a thorough review of the terms and conditions for both of these plans.
Long-Term Disability Retirement Planning: Employee Benefits in Disability
If you have recently transitioned from short-term disability income insurance (STD) to receiving LTD benefits, you may have questions about how the more extended timeline affects your long-term financial prospects. Depending on your age and prognosis, you may be especially concerned about how LTD affects retirement funds and your ability to contribute to them. Understanding the overlapping frameworks under which long-term disability and retirement planning are typically managed can help you to get a stronger sense of the factors that are likely to have the largest impact on your personal situation.
Long-Term Disability and Retirement Planning: Understanding Retirement Savings as Employee Benefits
A majority of long-term disability income insurance coverage is obtained through employers. If you purchased your disability income insurance independently because you were self-employed or the partner in a business interest and employed but not working for a company, you may not have the same assortment of additional benefits to navigate as individuals whose LTD benefits are provided under an employer-sponsored group plan. Those LTD benefits whose policies are part of employer-sponsored group plan insurance are often coming from a work environment in which they also enjoyed a number of other benefits, including health insurance and 401(k) retirement savings plans.
How LTD Affects Retirement Funds: What Happens to Employee Benefits on Disability?
Most of these benefits that accompanied employment will not be directly transferrable to your post-employment situation, although that does not necessarily mean they will in all cases be a total loss. The Consolidated Omnibus Budget Reconciliation Act (COBRA) mandated certain requirements for most employer-sponsored health insurance plans to allow individuals losing that job-dependent health insurance to purchase temporary policy extensions, although at an increased cost. Even some group plan disability income insurance policies provide options for purchasing limited “conversion” policies that allow employees changing jobs to convert their employer-sponsored group plan coverage to individual LTD policies with the same insurance provider.
LTD Impact on Retirement Savings: What Happens to Your 401(k) When You Go on Long-Term Disability?
A 401(k) savings account is specifically an employer-sponsored type of retirement plan. Both the employer and the employee contribute to the funds in the account. Usually the employee’s contributions are withheld from his or her paycheck. Often these contributions are taken out before income tax withholdings, which can confer some long-term tax advantages.
The funds contributed by the employer “vest” progressively over time, so that the percentage of the employer’s contributions to the account that belongs to the employee increases gradually. Employers often use the 401(k) plans, and their own contributions to the growth of these accounts, as a tool for improving employee retention, allowing the fact that an early departure means forfeiting a portion of the employer’s contributions to serve as a deterrent to high turnover rates.
How LTD Affects Retirement Funds: Options for Transitioning a 401(k) to an IRA
If you have left your job due to a disabling illness or the consequences of a serious injury, then there may not be much you can do about any portion of 401(k) funds contributed by your employer that are not already yours. However, the full value of your own contributions will still belong to you.
For long-term retirement planning, this means both that individuals who have 401(k) retirement savings accounts do retain some retirement funds, and that these individuals will likely need to choose how to manage the 401(k)s formerly associated with their jobs until they are able to either return to work or transition from LTD to retirement. Converting the 401(k) to an individual retirement arrangement (IRA) is one of the most common options, but you may wish to discuss your long-term disability and retirement planning with an attorney before you make a final determination.
LTD Impact on Retirement Savings: 401(k) Withdrawals
Because a 401(k) is typically considered a “tax-advantaged” form of retirement account, making early withdrawals from 401(k) funds usually entails a 10% penalty tax. For this reason many individuals exploring how LTD affects retirement funds treat 401(k) withdrawals as a last resort, recognizing that access to funds in the present means fewer resources overall.
How LTD Affects Retirement Funds: 401(k) Early Distribution Tax Penalty
Under Internal Revenue Service (IRS) rules, however, people on LTD who meet specific criteria may be able to withdraw funds without incurring the usual tax penalty. Such withdrawals will obviously still shape the relationship between long-term disability and retirement planning, in the sense that funds withdrawn from the account are no longer available either to generate interest or to use during retirement, but the LTD impact on retirement savings may be reduced compared to a withdrawal made under other circumstances.
Long-Term Disability Retirement Planning: Early Distribution Penalty Tax Exemption for Qualifying Disability
To qualify to make a penalty-free 401(k) withdrawal, an individual must be “totally and permanently” disabled. Interestingly, the IRS does not set the criteria for disability that will allow for an “early distribution” from a 401(k) without the 10% additional tax. Rather, IRS guidance specifies that the 401(k) plan’s documents will establish the conditions under which an early distribution for disability qualifies for an exemption from the penalty tax.
How LTD Affects Retirement Funds: Managing Long-Term Disability Benefits
If some or all of your retirement savings were held in a 401(k) before you became disabled, consider speaking with an attorney about the pros and cons of converting the 401(k) into another type of retirement account, such as a Roth or traditional IRA. Take into consideration whether your primary concern is minimizing LTD impact on retirement savings vs. securing funds in the present to ensure you remain afloat financially. Any funds you withdraw will of course not be available for your long-term disability retirement planning, so how you set your priorities and LTD affects retirement funds may depend partly on how many years longer you would have expected to work prior to retirement, as well as on your current medical prognosis.
The options that make the most sense for long-term disability and retirement planning may be very different for a person who takes disability mid-career with a chronic illness compared to those that might work for an individual in their 50s, regardless of condition, and both will be different from the concerns of a person diagnosed with a progressive condition. Getting professional advice tailored to your circumstances can often make financial planning during disability much easier.
