Life insurance is a common and integral part of any strong financial plan. Without it, there’s potential to leave your loved ones in a dire financial situation. For example, it’d be important for them to maintain their current lifestyle and ability to make progress towards long-term financial goals such as college expenses or paying off the mortgage. However, the key question then arises — how much life insurance should you buy? In order to answer this question, it’s important to take a 30,000-foot view of your current financial situation and long-term goals. Only then can you get an idea of how much life insurance will be sufficient. This article will explore the two types of life insurance, identify what you’re protecting against, and ultimately determine how much life insurance you may need.
Permanent Life Insurance
The first type of life insurance is known as permanent life insurance. Permanent life insurance includes whole life, universal, variable, and variable universal policies. As the name suggests, permanent life insurance provides lifelong coverage. Permanent insurance policies also have an investment component known as the cash value.
The cash value grows tax-deferred over time, meaning you won’t pay taxes on gains while it’s accumulating. The caveat, however, is that permanent life insurance policies have much higher premiums to keep them in force compared to their counterpart, term insurance.
In the vast majority of cases, permanent insurance policies aren’t necessary. People are better off investing the difference between what they’d pay in premiums for a permanent policy and what’d they pay for the much cheaper, term insurance policy.
Term Life Insurance
As the name suggests, term life insurance provides coverage for a set term, or period of time. The policy owner pays the premiums to keep the policy in force for X amount of years until the term ends or coverage is no longer needed. There isn’t any cash value associated with term policies. Rather, their sole goal is to provide life insurance coverage. Therefore, the premiums associated with term insurance policies tend to be much lower than permanent policies.
What is Term Life Insurance?
Term life insurance is the most basic, common type and arguably the most useful. It provides a set death benefit for a set period. For example, a policy might be described as a $1,000,000 death benefit for 20 years. If the underlying insured person were to pass within 20 years after purchasing the term life insurance, then the policy’s beneficiary will receive $1,000,000. During that period, the policyholder will pay an annual or monthly premium to keep the policy in place. If the premium isn’t paid, the policy lapses. It’s as simple as that!
Generally, term life insurance is best used to replace the future loss of income of the insured and/or to enable the beneficiary to pay off existing debts (such as a mortgage), or fund future goals (such as education costs for kids).
Term Life Insurance Use Case
When you’re married or have kids, term life insurance almost always makes sense to implement. Let’s outline a scenario and how term life insurance may benefit a hypothetical family.
The Jones family consists of four members: two spouses and two kids. The spouses both earn similar incomes of $150,000 per year and carry a mortgage debt of $500,000. The kids are ages 5 and 2 and are currently saving for their children’s college expenses in a 529 savings plan.
The Jones have around $50,000 in cash for their emergency fund but not much else liquidity, with almost all their investments tied up in retirement accounts. From a financial planning standpoint, a large risk to their long-term plan is if one or both spouses no longer earned their income and couldn’t pay their mortgage and/or fund their children’s college goals. Therefore, they can use term life insurance to reduce the risk of these two scenarios significantly.
The Jones family should purchase term life insurance for $750,000 for 20 years at a bare minimum. This would be a baseline, simplistic way to approach life insurance. With the assumption that after 2o years, most of the mortgage will be paid down and the children will have entered or completed college, life insurance would no longer be needed.
They could also consider “laddering” the insurance and purchasing around $500,000 for x amount of years and another $250,000 for a lesser or greater amount of years, depending on when the amount of insurance needed changes. However, if the Jones’ wanted to purchase enough insurance to “replace” all future income of both spouses, the amounts would likely be much larger and in the millions.
There’s generally a baseline amount of life insurance a financial planner can recommend; however, above and beyond that, it becomes more of an art than a science. If your family is more comfortable with larger amounts of life insurance and fully replacing future income, purchasing more isn’t an issue. With the caveat that it will be more expensive as long as the policy premiums don’t hinder your cash flow or hurt other financial goals.
Other Benefits of Term Life Insurance
Term life insurance is extremely cheap relative to the risk it reduces and the benefits it can provide.
For a young couple in their 30’s with relatively good health, a term insurance policy for $750,000 and 20 years may cost somewhere between $250-$450 annually. This premium is “locked” for the term of the policy.
Therefore, inflation and your future health don’t impact the rate you pay for the policy. In contrast to what you pay for through group policies, many employers offer. They typically increase their premiums if you’re to leave the company or “re-up” the group life insurance in future years.
As mentioned above, term life insurance is also simplistic. It’s easy to purchase, maintain, and understand as a consumer. Whereas its counterparts are oftentimes complicated and expensive.
Life insurance policies known as Whole Life or Universal Life do contain a death benefit but also contain other bells and whistles that, in the vast majority of cases, are NOT NEEDED. If you’re primarily looking to insure against the risk of loss of income, term life insurance will always be the best option over its more expensive and complicated counterparts.
Term or Permanent Life Insurance?
As I mentioned before, the vast majority of people who need life insurance can get their coverage through term policies. However, permanent policies can make sense in certain situations, such as preparing for estate taxes, care for a disabled child, and/or liquidity for a business. If you’re considering purchasing a permanent life insurance policy be sure to fully understand why it’s being recommended and whether a term policy would suit your needs better.
Unfortunately, many permanent policies are sold because of their high-paying commissions to “advisors”, not necessarily because they’re in the best interest of the person purchasing it. Most people just need cheap coverage through term life insurance and can invest the amount that would otherwise go towards the premiums of a permanent policy. This strategy will likely have a greater long-term wealth-creating impact.
What Are You Protecting Against?
First, identify what you’re actually protecting against. If you were to die today, would your family be able to survive without your income? The answer is likely no, or if they’re able to, they’re drastically altering their current lifestyle and ability to make progress towards long-term goals. Therefore, protecting against loss of income today and into the future is a primary driver for purchasing term life insurance.
Secondly, what are your current debt obligations? Do you have a mortgage that your family will be responsible for if you were to pass? If so, they’ll likely need coverage to help them pay off the mortgage. Do you have kids that you hoped to send to college someday? Additional life insurance coverage could allow that to happen.
Determine the Necessary Coverage and Term
Once you’ve established that you’re protecting against a loss of income and future financial goals, you can determine the actual amount of coverage and amount of time you’ll need that coverage for. If you have 14 years until your kids go to college, 25 years left on your mortgage, and 30 years until your spouse will retire, it’s better to pursue a policy that will extend until the LATEST date that coverage will be needed. In this case that would be 25 or 30 years.
If you have a mortgage for $350,000, assume it will cost roughly $250,000 for two kids college expenses (future cost), and additional coverage to replace your income, you could assume you’ll need anywhere from $750k to $1 million in life insurance coverage for your family to comfortably meet their needs today and into the future. This is assuming the death benefit paid out upon your passing could go towards paying off the mortgage, be invested for the kid’s future colleges expenses, set aside as cash for lifestyle expenses, and the remainder invested for future lifestyle expenses.
Not to mention, purchasing term life insurance while you’re relatively young is a very cheap way to ensure you’re covered up until the end of your mortgage or retirement. The premiums will never increase even as you age.
Other Considerations
When determining how much life insurance to purchase, you’ll also want to consider what your employer may offer through their group policy. Oftentimes, employers will provide free coverage to their employees (they pay the premiums) as an added benefit. It may be structured as 1 or 2 times your base salary in life insurance coverage. This coverage should be factored into your overall coverage when determining how much to buy through the private marketplace.
Your employer may also allow you to buy more insurance through their provider at potentially cheaper rates than in the private marketplace. However, the downside to purchasing more coverage through your employer is they may require you to provide “evidence of insurability” upon leaving employment. In short, your premiums could increase down the road since you’ll be older and a higher “risk” to the insurance company.
Buying coverage through the private marketplace ensures your premiums will remain intact as long as the policy remains in force and therefore extremely cheap as time goes on.
Life Insurance Decisions are Important
Life insurance, while not the greatest of subjects to discuss with your family or loved ones is a necessary part of any strong financial plan. Without it, the situation is only worsened as family and loved ones have to learn how to live without an additional income and their path to achieving other long-term goals is no longer clear.
If you need help from a fee-only financial advisor (we’re not compensated with commissions whatsoever) to determine how much and for how long you and your family may need life insurance, schedule a free consultation with us today!
