Life insurance is always a very heated topic in the personal finance world; there are those who believe it’s vital in financial planning and those who say it’s useless. I belong to the first group; life insurance is a vital part of sound financial planning.
One of the most common questions about life insurance is “how much do I need” this is even more true for younger individuals, I constantly receive emails or see questions on forums posted by twenty something’s asking this question. Most recently a reader provided me with his situation asking “Do I need life insurance and if so how much?”
Let’s call him Jason (I don’t want to use his name), here is his case:
- Just purchased a home for $167,000 (New Brunswick).
- I am a 26 year old government employee and my girlfriend is a 24 year old PhD student.
- Presently with work, my beneficiary would receive life insurance of 1 X annual salary whereas my girlfriend does not have a life insurance policy right now.
- We have no kids or other dependants (but will someday I’m sure).My thinking is that if I were to pass away, my girlfriend would probably look to sell the house. She would receive my 1 year salary to help her out, and would also have both sets of parents able to help out. On the other hand, if my girlfriend was to pass, I could still afford the mortgage payments myself, but it would be more of a financial burden (would evaluate my needs at that point). If we had kids, then there would be no question that I would want extra life insurance.
So in short, should I look into life insurance? If so, should I look into coverage of a little over the mortgage amount ($200,000 for instance)? Or should I wait until I have children?
Thanks again!
This is a very typical situation and I get questions of this nature regularly, so I thought I’d share it with everyone.
There are two fundamental questions here:
1. Do I need Life Insurance?
2. How much do I need?
Question 1
The purpose of life insurance is to protect your loved ones in case something was to happen to you. This need is usually nominal at the early stages in life, increases as the family expands and children are added to the equation, and diminishes once children move out and couple’s reach retirement. Jason is in the early stages of his life, it seems his only debt is the mortgage on his house which he shares with his girlfriend. Jason also has some group life insurance through his employer (not sure what the amount is) which would cover some of his debt. Does Jason need life insurance? Maybe. If he has a good cash flow and can afford a guaranteed term policy than he may want to look into it. Since Jason does not have dependents (yet) and has some coverage through his employer it is not vital for him to have an individual policy. However, it seems he is planning on having children in the future which means more expenses and probably moving to a bigger home and so on – at which point he will definitely require life insurance. If Jason can afford to purchase adequate amount of life insurance at his current age and health status, it can save him on premiums later on. I don’t believe that he needs individual insurance right now, but it maybe a sound long term decision.
Question 2
Should Jason decide to go ahead and purchase an individual life insurance policy, the question will be how much does he need right now? This by far is the most common question when it comes to life insurance “how much do I need?” Insurance agents will tell you “as much as you can afford” (the more you buy the more they make), I generally use this rule of thumb:
Insurance Needed = All Debt + Estimate Funeral Costs + Income Replacement – Current Coverage – Liquid Assets.
Note that this is a very general rule of thumb; it may change with different situations. This gives you a rough estimate of how much you would need and you can customize it from there. Since Jason’s case is a fairly simple case he can use this rule to determine the amount needs currently!
Insurance should NOT be Static!
Life insurance is needs based, and your needs change over time. One common mistake is that once people purchase a policy they just forget about it. Remember you are buying life insurance to protect your loved ones in case something was to happen to you, but your situation changes over time. You may have children, you may move to a bigger house, a change in lifestyle, etc. All these changes require you to review your life insurance policy at least annually to ensure it still meets your needs.
Jason can purchase a small life insurance policy to meet his current needs and as his situation changes he can modify the policy to meet his new needs.
What do you think of Jason’s situation? Should he just forget about it? Any tips to help him and others in similar situations out?
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I typically leave debt out of the insurance equation. My theory is that if I’m paying off the debt now and I provide income replacement, my heirs should be able to pay it off on the same schedule with the income replacement. But then the only debt I have is a mortgage…
Ray, have you checked thought about a VUL (variable universal life insurance)? Depending on your tax bracket and investment strategy, it could be an ideal way for you to take advantage of tax free growth, tax-free withdrawals, and no penalties for withdrawing prior to 59 1/2. It’s not for everyone but it’s worth your time to check it out.
http://en.wikipedia.org/wiki/Variable_universal_life_insurance
Ray, it seems like she may be dependent on his income, only if slightly. The formula I normally use for income replacement is a little simpler than yours, but I find easier is usually better. Here’s what I do to get to an initial figure to discuss:
(income that needs to be replaced) / (interest rate beneficiary would expect over a long time) – (liquid assets and assets beneficiary would sell) = (life insurance amount)
As an example: $35,000 / .06 – $15,000 = $568,333
Note that this formula takes into account the risk tolerance of the beneficiary when they might manage the money over time (not Jason’s risk tolerance). It also incorporates her probable plans with the house into the equation. If she plans on selling it, any equity could be accounted for, but her need for income might increase.
Like I said, I see this formula as the starting point for an important discussion about his life insurance amount, not the be all and end all. It’s shooting from the hip.
If she wouldn’t need to replace any of his income, then that might also answer their need and they could talk about whether insuring his insurability makes sense.
@Randy..I guess that could work if you will replace 100% income for a long term, but it could end up being a very large policy. I find it easier to pay off the debt and replace income for 1-2 years.
@ Freedincome…I am not a big fan of UL policies, I think that life insurance main purpose is to protect your family in case something were to happen to you, for investing and tax sheltering there are better options out there. UL policies are too expensive and often not worth the effort. There are very rare case it makes sense to have a UL policy and it’s usually with affluent clients
@Aaron…I use the same formula if I am just looking at replacing income for the long term, but in this case my thought process is….she is not depended on his income, mortgage is the only debt so pay off mortgage and replace the income for a year or two. I generally do not look at replacing income for the life time, a few years of income replacement is enough in most cases but not always.
I hear ya. That’s why I say that formula is just a starting point for a discussion. Who knows what her income replacement needs really are or how long of a time frame they should really consider?? They do.
I don’t think anyone can tell them the answer about how much life insurance they need, but they can come up with one once they understand how it works.
@Ray what other tax sheltering options have you come across?
@ freedincome– I am not sure if you are located in Canada or the US, but for most people retirement plans like the RRSP and 401K, TFSA and ROTH IRA …is more than enough to shelter taxes….other than investment advisers can help in creating tax efficient investment strategy based on your needs. Often insurance people push for UL products because commission is much higher on those as they are the most profitable products for insurance companies.
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