Standard formulas -- such as buying coverage equal to eight to ten times your annual income -- are inadequate shortcuts. The truth is that life insurance is a personal affair. Two couples may earn equal salaries, but it’s silly to say that someone with four young children should have the same coverage as empty nesters with no mortgage and a substantial retirement fund.
A simple strategy. The purpose of life insurance is to allow your family members to pay the bills and live their lives as planned despite your absence.
Here is a simple strategy to calculate how much coverage to buy and to form a plan that’s easy to update. The idea is to assess whether you need extra coverage or different policies only after you project your life-insurance needs as the sum of four categories.
- Final expenses. A funeral, burial and related expenses tend to cost $10,000 to $20,000. Your beneficiaries may be able to get the tax-free proceeds from insurance faster than if they waited for money from your estate. Use $15,000 as a ballpark number.
- Mortgages and other debts. Total your mortgage balance, car loans, student loans and any other debts that would be a heavy burden on your survivors. They may choose not to retire the mortgage, especially if the interest rate is low, but the money should be available so that they won’t face the prospect of being forced to sell.
- Education expenses. This calculation can be tricky because you need to consider the cost of college at the time your kids enroll. Here's the solution. College costs have been rising by about 5% a year. I recommend looking up current costs for colleges you’re considering, deciding whether you want the insurance to cover all or a portion of the tab, and adding the amount in today’s dollars to your life-insurance calculation.
- Income replacement. Once you cover funeral expenses, debts and education, your family won’t need to replace 100% of your income -- and that’s where the art part of the calculation comes in. I recommend covering 50% of current pretax earnings until retirement. You can translate this into a target lump-sum benefit by dividing it by 0.05. For example, if you earn $100,000, divide $50,000 by 0.05, which works out to $1 million. That assumes the insurance benefits will earn 5% a year over the long haul, a conservative back-of-the-envelope figure.
Add all four categories to estimate how much life insurance is appropriate, then tweak the number to reflect personal circumstances. You might increase it if you don’t have a pension, but you could decrease your coverage if your spouse earns a substantial salary. If you or a family member has a troublesome medical history, add $100,000 or even $250,000. If you’re the one with the medical condition, you’ll find it tough to buy additional coverage later at a price you can afford.
For most families, this exercise will work out to an amount in the high six-figures, possibly even $1 million or more. But don’t be frightened. With term insurance, boosting your death benefit by hundreds of thousands of dollars should cost just a few hundred dollars a year.
Some term policies come with the right to convert to permanent life insurance, which you can keep for the rest of your life regardless of health. Premiums will be higher than for term at the beginning, but they usually remain level indefinitely. The best reason to consider universal-life insurance isn’t the accumulating cash value, although that’s part of the deal. The real issue is whether you’ll need coverage beyond 20 or 30 years -- or after age 65, when term gets expensive. You might want permanent insurance, for example, if you need to protect kids with special needs who will always rely on you (or your estate) for support, or if you want to leave money to a school, charity or your children and you don’t expect to afford it any other way.
You need more life insurance if you...
- Tie the Knot.Your new spouse might depend on you even if he or she earns as much or more than you do.
- Have a Child.It takes a lot of money to raise a child--and it doesn't get any cheaper if you're not around.
- Buy Your Dream House.When you settle into your family's permanent home, guard against its loss in case tragedy strikes.
- Are About to Retire? No more insurance from work. If you die, your spouse could lose pension and some Social Security income.
But it can make sense to combine term and permanent insurance with multiple policies or by buying a convertible-term policy and making a series of conversions over the years. One advantage of a convertible-term policy is that insurers don’t require a new medical exam when you make the conversions. That essentially gives you a pass if you gain weight, develop high blood pressure or even survive a bout with cancer.
Example for a 27-year-old man who starts by paying $357 ($29.75 per month) for $500,000 of term insurance, and then gradually converts it to a universal- life $100,000 at a time. If you shift $100,000 to a universal life at age 28, your annual premium would jump to $1,100. If you shift another $100,000 at age 31, your premium would rise to $2,600. Your premium would gradually increase whenever you shift money to the universal-life policy, topping out at $7,200 at age 40, for the entire $500,000 of universal-life insurance.
The policy’s cash value will rise every year, as will the death benefit. By age 65, in this example, the benefit is projected to be $990,000 and the cash value $475,000, which can be borrowed, withdrawn or tapped to keep the policy in force without paying additional premiums.
If you have questions about your existing policies or would like free information about how to protect your families financial future... We can help!
I wanted us both insured. I wanted myself insured because I am the sole wage earner and needed my family to be secure if anything should ever happen to me but I also wanted my husband insured simply because he was the “stay at home parent” and, at the time, I would have found it very difficult to work full time if anything had happened to him.
ReplyDeleteI just recently had a child and I'm currently thinking of getting life insurance for me and my family. Thanks.
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