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.
Term or Permanent?
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 of 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.
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.
The Bottom Line
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!
Levi Sanchez is a CERTIFIED FINANCIAL PLANNER™, BEHAVIORAL FINANCIAL ADVISOR™ and Co-Founder of Millennial Wealth, a fee-only financial planning firm for young professionals and tech industry employees. He is an avid sports fan, personal finance and investing geek, and enjoys a great TV show or movie. His mission is to help educate his generation about better money habits and provide financial planning services to those who want to start planning for their future today!