Life insurance is a waste of money–unless you die!
I have never had a widow tell me that her husband had too much life insurance! Of course, some of them did have more life insurance than they needed, but no one ever complains about having more money than they need.
If someone else depends on your income, you should take the time to think through a scenario of that person suddenly not having your income. Once you realize there is a need, there are two questions to answer: how much should I buy, and what kind should I buy?
Step One: How much should I buy?
The first piece of information you will need to know is how much of your income needs to be replaced. This is calculated simply by adding up all of your expenses and subtracting the income that will be available to meet those expenses, not considering any existing or new life insurance. Be careful not to underestimate your expenses just because you know that the lower your expenses, the less life insurance you will need to buy. Follow these simple steps to help give you a starting point for discussion:
Annual Expenses
Less:
Surviving spouse’s net paycheck
Social Security – spouse
Social Security – children
Retirement income – current
Other income
Total potential income
Income shortage
To come up with a reasonable amount of life insurance to produce the annual income shortage, simply divide the income shortage by 5% (0.05). For example, if the income shortage is $20,000, the amount of life insurance it would take to provide $20,000, assuming 5% earnings would be $400,000. If you already have $100,000 through your employer and/or an individual policy, you need to purchase an additional $300,000.
If you want to be more conservative (e.g., to account for higher inflation or lower earnings growth), simply use a lower earnings assumption. Conversely, if you thought the money wouldn’t need to last as long (e.g., your spouse is expecting a sizeable inheritance or would get a higher-paying job when the kids were out of the house), simply use a higher earnings assumption.
This is an over-simplified way of calculating the amount of life insurance you need, but it will at least give you a reasonable estimate.
Step Two: What kind should I buy?
Term life insurance is what I recommend in the vast majority of situations. If you are 30 years old, consider buying a 30-year level term life policy. It is also worth considering combining several term policies. For example, if the children will be done with college in 15 years, buy a 15-year term policy for $200,000. The other $200,000 you need should be a 30-year term that will take you until you are almost retired.
Of course, along with buying the term life insurance, you need to be putting money aside in your 401(k) or an IRA (Roth or traditional) so that when the term life expires, you have enough assets for your surviving spouse to live on.
If you think you will have a need for liquidity at death, or at least well into your retirement years (for things like a potential estate tax liability or your assets are tied up in illiquid assets like real estate), you should consider buying some permanent life insurance. Permanent life insurance is either whole life, universal life, or some version of these two. Typically, I recommend buying a whole life policy from a “participating” life insurance company (such as, Northwestern Mutual or Massachusetts Mutual). The amount you should buy depends on your circumstances, but I rarely recommend having more than $100,000 (and usually just $25,000 to $50,000).
What about accidental death and dismemberment (AD&D) insurance (or a rider on an individual policy)? If you can buy it very inexpensively and the cost doesn’t derail the rest of your financial plan, I don’t have a problem with someone buying it. Obviously, if you died in an accident, it would be a good deal. However, I believe one of the main reasons the cost for this type of insurance is so low is that the odds of dying by accident are low.
Remember, it is just for death by accident. I had a call from a radio listener who asked about collecting a death benefit from an AD&D policy. She told me that her husband had a heart attack. I told her that this type of policy paid only in the event of death by accident. She quickly told me, “He didn’t mean to have a heart attack. It was an accident!”
Finally, be sure to work with an independent agent who can shop around for the best price for you–especially if you have any physical issues. Insurance companies price diabetes, obesity, high blood pressure, etc., differently (depending on their own loss ratios). Be sure to check with your employer or professional association to compare prices–especially if you have a physical issue.
Take care of this TODAY! Your family will be forever grateful!
