When you're self-employed, it's crucial to consider how you'd support yourself and your family if you were incapacitated due to illness or injury.
For example, If you couldn't work in your business, could you still pay yourself dividends to cover the mortgage or bills? If not, how long would any savings last if you have nothing coming in?
If you're at all concerned about how you'd manage, an income protection (IP) policy could be the perfect solution.
And it's not just for homeowners either. Income Protection can be just as useful if you rent your home.
This guide explains what income protection is, how it works and the different options available. It also examines key features of IP, such as deferment periods, and how the maximum monthly benefit is calculated.
What is Income Protection Insurance?
Think of Income Protection Insurance as sick pay for the self-employed. An income protection policy provides you with a monthly, tax-free, income if you're unable to work in your chosen profession due to illness, injury, or disability.
Sometimes referred to as Permanent Health Insurance, or PHI (not to be confused with Private Medical Insurance or PMI), Income Protection covers a broad range of illnesses and injuries including, but not limited to:
- Back pain and other musculoskeletal problems
- Mental illness, including depression or stress-related issues
- Heart Attack or Disease
- Fractured bones
In fact, IP will cover you for a very broad range of illness or injury that prevents you from working in your business, as long as you've been signed off work by a GP or other medical practitioner.
The only caveat is that medical exclusions can be applied to pre-existing conditions, or if there is a family history of such a condition or illness.
How does income protection work for the self-employed?
Income Protection allows you to choose the monthly benefit level you want to receive, up to the insurer's maximum percentage of your current gross monthly income, typically 65 percent.
Others permit 65 or 70 percent up to a certain income level of around £60,000 p.a, then a lower percentage on anything above.
In the event of a successful claim, the benefit is paid tax-free every month until you return to work, retire or pass away during the policy term, or the policy term expires.
You can make an unlimited number of claims during the term of the policy. Even if it's a reoccurrence of the same condition that prevented you from working initially. Cancer or back pain for example.
How the maximum monthly benefit is calculated
Your maximum benefit amount is calculated using your personal tax calculation for the latest year at the point of application.
For example, a director with a 22/23 tax year income (salary and dividends) of £62570 per annum, could potentially qualify for a maximum benefit amount of £3389.20 per month at 65% of gross income.
The calculation is gross annual income x maximum percentage, divided by 12. In the above example: (62570 x 0.65) / 12.
You could of course, choose a lower benefit figure, reducing your monthly premium accordingly.
What happens when I claim on my Income Protection policy?
When you claim, the same calculation will be run using your income for the 12 months before becoming incapacitated.
If your income has reduced from when when you took out the policy, you'll receive a lower monthly benefit, though some providers guarantee a minimum benefit level, typically around £1500 a month.
If your income has increased, you'll still only receive the maximum benefit amount you applied for initially.
Setting a deferment period
The deferment, or wait period, is how long you must wait to receive your first benefit payment after becoming incapacitated. The longer the deferment period, the lower the premium.
It's possible to set a deferment period of one day, all the way up to two years. In reality, most self-employed applicants choose one, two or three months.
To determine a suitable deferment period, you'll need to consider how long you can comfortably pay your mortgage (or rent) and other bills if you're income reduces or stops altogether. Bear in mind, savings can dwindle rapidly with nothing coming in, and in any case, you may not want to risk using them all up.
Standard vs Short-Term Income Protection
Standard Income Protection, a.k.a Full Cover to Term IP, pays you the benefit amount each month during the policy term until you return to work, retire or pass away.
So potentially you could receive the payment for many years, even decades.
Short-Term IP on the other hand, typically pays you for a maximum of two years per claim. So whilst it's cheaper than standard IP, it does mean payments will stop after two years, even if you're still unable to return to work at that point.
You can still make multiple claims during the policy term, but each claim will only pay out for a maximum of two years.