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What Is an Income Replacement?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 28 March 2014
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Income replacement is the process of replacing lost income, due to factors such as extended illness, a permanent injury, or even retirement. The goal of income replacement is to substitute some other source of income for at least a portion of the lost income, usually enough to allow the individual to continue enjoying a standard of living that is similar to what he or she has enjoyed previously. Depending on the lifestyle of the individual, this usually means seeking income replacement that amounts to anywhere between sixty and ninety percent of the previous income.

In situations where employees are unable to continue working due to illness or injury, there are two different approaches that may be implemented in order to manage income replacement. One approach has to do with provisions found within the employment contract. It is not unusual for employers to include a clause that guarantees the employee will continue to receive his or her usual salary for a limited period of time after being declared disabled by a qualified medical professional. Often, this clause allows the employee to enjoy a continued monthly income long enough to qualify for other forms of support, such as a government sponsored disability program.

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A second approach to income replacement has to do with maintaining insurance that guarantees some type of monthly income in the event of illness or permanent disability. While the names for this type of coverage vary somewhat around the world, many insurance providers who offer this type of coverage will refer to it as income replacement benefits. Generally, this type of coverage will not equal the monthly salary or wages normally generated by the insured party, but will provide a fixed monthly benefit. With this approach, it is up to the consumer to determine how much income is needed to maintain a decent standard of living, and structure the insurance coverage accordingly.

With retirement, income replacement involves the activation of other sources of income to maintain the standard of living. The retirement income often is composed of processed from a pension fund that was established through the employer, and any government supported program that the employee paid into each pay period over the years. Depending on the tax laws that apply, the retiree may owe taxes if his combined income replacement exceeds a certain amount annually.

While there are situations where employers may offer income replacement outside of the employee contract, such as in a verbal agreement, this type of arrangement can be somewhat risky. Should the officer who provided that verbal assurance die or choose to leave the company, proving that the agreement was ever made may be extremely difficult. For this reason, including the replacement assurance within a written document is highly recommended.

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