When I started my current job there were a lot of new benefit options I had to consider. When you have a wife and kid(s) things like insurance suddenly matter. Disability insurance like life insurance is one of those touchy subjects that no one really wants to talk about. Mainly because it means you are planning for something bad to happen to you. However, it is an important part of securing your financial future.
Disability Insurance is for when you get hurt temporarily or permanently and cannot work. Investopedia's definition only pertains to social security disability but that is a pretty limited definition.
Types of Disability Insurance
Typically there are two types of disability insurance; Short Term Disability (STD) which lasts for around 8 weeks and is the most commonly used and Long Term Disability (LTD) which lasts until you die or draw social security of social security disability (depends upon the plan). Social Security disability benefits fall into the LTD category and you can generally only receive benefits if you meet a very strict standard of illness/disability. Often privately paid insurance will cover lesser degrees of disability including temporary disability. Generally employer sponsored programs will guarantee your job while you are out on disability. You can check your estimated social security disability benefits by logging into the social security administration's website.
What about taxes?
Benefits from disability insurance plans whose premiums are paid by your employer or in pretax dollars are taxed as income. This means that you want those benefits to be close to 100%. In my case my employer provides short term disability insurance at 50% my base pay. I don't pay for additional short term disability insurance instead I account for the remaining amount (50% at 8 weeks) in my emergency funds.
Benefits from disability Insurance plans whose premiums are paid by you in after tax dollars are usually tax free. This means you really only need benefits of approximately 70% of your wages (depending upon the tax rate in your state).
You generally will owe payroll taxes (social security and medicare) on all STD benefits and the first 6 months of LTD benefits.
Bottom Line, how much disability insurance do I need?
For STD you need 100% of your income minus any amount you have in your emergency savings. STD is usually only for about 6-8 weeks so you can even get away with no STD insurance if you really want.
For LTD it gets a bit more complex, you want 100% minus income tax and payroll taxes. That being said you need to account for payroll taxes for about 6 months, my preferred method would be in the form of emergency funds. You should also factor in disability benefits from social security (or your state if they have a public program) you should also consider the application time for each program.