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How to protect earnings if you are unwell using income protection policies

You can apply for income protection policies that provide a level of cover based on your annualised contract rate, and not just on your low company salary.

Many specialist advisors in the contracting market have access to special contract rate-based policies ensuring you can still get paid if you are unwell.

Why you need a specialist income protection policy designed for contractors?

Income protection policies traditionally provided a monthly income based on a percentage of an employee’s gross salary if they are unable to work through illness or injury.

Historically this approach used to work against limited company contractors, who tend to take lower salaries for tax-planning purposes that are then bumped up by dividends. This used to leave many thousands of contractors underinsured and some paying for protection that would not pay out in the event of a claim.

And whilst some schemes will protect dividend income, this only works if all income every year is withdrawn as dividends - which again isn't ideal and rules out being able to retain profits in the company - which contractors need to do for both tax reasons and to build up a buffer for low work periods.

The solution is policies based solely on contract rate

If the income protection policy is based on contract rate, then you can claim a far higher income if you are unable to work due to illness or injury. And such a gross contract approach is unaffected by the salary or dividend that you choose to draw from your limited company.

Income protection policies based on annualised contract rates can be of huge benefit to you: Calculating, and proving, an employee’s salary and using it to calculate the income from the policy and its premiums is straightforward. However, you not only have a low salary relative to your total earnings, but your income may also fluctuate on a monthly basis during the course of a year as you change contracts. Basing income and premiums on an annualised contract rate can allow for this.

An example - what will a policy pay out?

A contractor earning £30 per hour working 35 hours per week for 52 weeks of the year could earn a gross annualised contract income of £54,600. Based on this ideal annualised sum, a contractor taking out a basic income protection policy could expect to receive £2,275 per month, which is 50% of their annualised contract income, if they are unable to work.

And contractors can opt for higher cover, depending on their personal circumstances: There are income protection policies that will provide incomes of up to £12,500.

How much are the policy premiums?

Costs can vary depending on the level of cover required, but a typical 36-year-old non-smoking male IT contractor with no medical conditions can cover themselves to age 60 for just £49 per month. For this monthly premium the contractor would receive an income of £2000 per month if they are unable to work due to illness or injury, and the policy would begin to pay after a three-month deferment. [Figures correct at time of writing].

However, every contractor and their personal circumstances are different, and so individuals should consult aspecialist contractor financial adviser before making any decisions, particularly as a contractor’s circumstances can change over time.

Premiums can vary considerably according to occupation, age, pre-existing medical conditions, family medical history, the policy’s length and other factors such as lifestyle. Another important factor is the deferment period – the time a contractor is not working before the policy is activated and they start taking an income from it.

Depending on a contractor’s personal circumstances, policies are generally best taken out personally, rather than through the contractor’s limited company, to avoid the benefit being subject to income tax under Pay As You Earn (PAYE) when it is claimed. The income paid out by the policy itself is tax-free if the premiums have been paid personally.

The main reason you should have income protection

Most employers have policies that provide their employees with long term sick pay to run alongside their statutory sick pay. As a result, many permanent staff can expect to receive their full pay for extended periods that can be a long as twelve months or more, depending on the employer.

But as a contractor you simply don’t have this perk of being employed: If you can’t work because of an accident or illness, then you won’t get paid. And if you don’t have savings, you and your family could rapidly run into financial trouble, possibly losing your home as state benefits just won’t cover the costs.

Sadly, some freelancers and contractors take out unsuitable accident, sickness and unemployment cover, which can lead to a false sense of security. These policies will often only pay out for a very limited time, and in many cases are inappropriate for those on short-term contracts, which could leave you dangerously exposed.

An income protection policy can maintain a minimum level of income to cover mortgage costs and bills until the contractor recovers or could provide a vital source of income until retirement if the condition is long term.

More than half of the 2.62 million people in the UK on incapacity benefit have been off work for more than five years. And in the short-term, nearly 25% of all people aged 35 will at some point during their working life suffer a disability lasting more than three months. So, an income protection policy should really be viewed by you as a ‘must have’, not a ‘nice to have’.

Updated: Thursday, 26 October 2023

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