What’s the one thing that can undoubtedly ruin a financial plan? An untimely death. It’s the one thing that immediately pushes aside retirement, college, home ownership, or really any plans you may have made for your family. Life insurance can often be the solution.
If anyone else is relying on your income, and would be unable to pay their bills without your support, you might want to consider life insurance. That means parents of minor children, but also anyone financially supporting their parents, spouse or any other family member as well.
Finding the Right Insurance
A term life insurance policy can meet most individuals needs. This is a policy that’s set for certain period of time, or “term,” such as 20 or 30 years. The goal is to have term insurance up until either:
- No one is relying on your income anymore
- You’ve built up large enough financial assets that, in your absence, those assets could sufficiently support those who do rely on your income
Permanent life insurance is meant to cover a buyer for the entirety of their life, on the assumption there is an insurance need that won’t go away any time prior to their death. With minor exceptions, such as those with a special needs child, the additional expenses associated with permanent life insurance make it not the ideal tool to meet a life insurance need.
How Much Life Insurance Do You Need?
Often, people might need more life insurance than they think. But since that answer is inadequate , let’s look at the different components that impact how much life insurance you need. Depending on many other elements of your financial plan, your insurance need changes, which is why going only by broad rules of thumb can lead to being significantly under or over insured.
Age:
Generally speaking, if you have an insurance need, you will need more insurance when you are younger and less as you age. If you’re 32 and have two young children and a brand new mortgage, it’s likely you have a larger insurance need today than you will in a decade when the children are older and much of your debt has been paid down. But, not everyone’s life follows that exact path.
Debt:
What debts do you have, and will they all need to be paid off by your death? Most debts must be settled by your estate, but most federal student loans do not. Thus, $100,000 in mortgage debt would need to be repaid either at death or over time, but $100,000 of most direct federal student loans would be discharged at death and your estate is NOT responsible for paying it off.
Family situation:
How many children you have, their ages, and what you hope to leave them all play into your life insurance calculation. Even if incomes are identical, someone with one child who is 12 needs less life insurance than someone with three children who are all under the age of 5. There are many more years of costs that must be met for a family with younger children.
In addition, the ratio of your income to your spouse’s income matters. If you earn 80% of the income in the household, your insurance need is likely greater than someone who earns 30% of the income for the household, even if your incomes are identical.
Financial goals:
If you’re planning to fully fund your kids’ college education, you need more insurance than someone who does not include that on their list of financial goals.
Savings rate:
Take two people who each earn $150,000 per year. Person A saves $30,000, and spends (including taxes) the other $120,000, Person B saves $10,000, and spends (includes taxes) the other $140,000. Person A has a lower insurance need both because they spend less money each year and because they will have accumulated more assets than person B, due to their higher savings rate.
This may lead to only very small differences in the short run, but compounded over a decade or several decades, the insurance needs are vastly different.
Burial Costs:
For most people this is a smaller part of the overall need, but should be factored in as well. If you intend to be cremated, your end-of-life expenses are likely less than someone with a burial wish. The average costs for a funeral with burial and vault is just over $9,000, according to the National Funeral Directors Association.
Other current financial obligations:
A horrible irony is that often enough those who have significant life insurance needs are those least able to afford the monthly premiums to adequately insure their lives.
If your budget is tight month to month, and you’re working to pay down debt and accumulate retirement savings on a limited income, you may end up opting for a smaller insurance amount than your circumstances require. The tradeoff is one some people are required to make.
Life insurance needs often decline over time, so the amount of insurance you need now will be far greater than you might need in 15 to 20 years. A life insurance ladder can help you build an insurance plan that adapts to your changing financial circumstances. You can either increase coverage if necessary, or allow your insurance coverage to taper off over time so that you don’t pay a premium each month for insurance that is far beyond your need by the time you pass away.
6 Uses of Life Insurance
While there are more than six uses of life insurance in comprehensive financial planning, the six below are certainly the most popular, especially in light of potential changes to tax laws.
Income Replacement
The central reason of why most people get life insurance is income replacement to help ensure your family still has money when you pass.
If you’re in your core earning years, income replacement is especially important. During those core earning years, while there is a low risk of death, there is a risk should death occur.
There will be a lot – emotionally and financially – for your loved ones to deal with in the event of an untimely death. Worrying about how to pay the mortgage and pay for funeral expenses shouldn’t be among them.
College Planning
Another use of life insurance is putting a policy in place and leveraging the cash value to pay tuition. But if you take this route, you’ll need a long runway or high rate of return to build enough cash to be able to pay tuition.
A benefit of this strategy is that the cash value of your chosen policy doesn’t go into the expected family contribution (EFC) for consideration in financial aid, so you might get some additional help from student loans or grants.
The downside is that growth could take much longer than in a 529 investment portfolio. It’s important to talk with your financial advisor to ensure you’re using the strategy that best fits your situation.
Retirement Planning
Life insurance isn’t an investment, but it does have that savings component. Think of life insurance as another bucket – you put money into your 401(k) or you put money into your Roth IRA. Life insurance is a conservative portion of your investment portfolio that allows you to put in money on a tax-deferred basis, and unlike other choices, you get to control the flexibility and the options.
If properly put together and funded, you can take out a tax-free income over a period to supplement your retirement.
Tom Hegna, retirement income planning expert and author, said he’s moved some of his personal wealth into a cash value life insurance as a source of tax-free income in retirement.
“I think tax-free income in retirement is going to be more important every year,” Hegna said.
Life insurance can also be used to replace income from your pension or Social Security. Lastly, it can be used to cover long-term care costs. A lot of modern policies even have benefits for long-term care.
Tax Diversification.
Hegna noted that in order to make up for underfunded obligations like Social Security, Medicare, Medicaid, and government and military pensions, taxes are going to have to go up.
With life insurance policies with cash value, the cash value grows tax-deferred within the contract, and beneficiaries are paid federal income tax-free. Under Internal Revenue code 1035, older contracts with cash value that aren’t performing well can be exchanged for a newer policy tax-free.
Business Needs
Using life insurance and buy-sell agreements upfront can help ensure continuity of the business. Whether you have two partners or multiple partners, you need to make sure that the business is passed to those who have an interest in it.
Estate Planning
We all have an estate. Our goal with using life insurance in estate planning is to make sure you’re passing your estate efficiently and in the manner that you want to. There are always going to be expenses that come along with an estate. Life insurance provides liquidity to pay for some of those expenses and estate charges.
“Wealthy people often say they don’t need any life insurance – and they may be right in the traditional sense – however, they need a way to transfer wealth to their family in the most efficient way possible,” Hegna said. “Life insurance allows you to transfer large sums of wealth for pennies on the dollar.”
Other strategies include using an irrevocable life insurance trust to mitigate estate taxes. To go along with that, it’s important to stay up to date on potential changes in estate taxes, which will be a bigger conversation in the next 18 to 24 months.
It’s critical to explore ways to use life insurance as part of your comprehensive financial plan to meet your goals. If you aren’t sure how to do that, contact a professional who can help
