Once upon a time, buying life insurance was as simple as the insurance man coming to your house, selling you a policy and coming by weekly to collect your premium. We learned something from this experience once our older relatives passed, those insurance men didn’t have their client’s best interest at heart. They were merely making a sale. Today life insurance, like many financial instruments, is very complicated. Not only must you decide between term (temporary) and perm (permanent) policies but the most important decision is face value.
Life insurance can be used not only to cover your burial expenses but also to create generational wealth. Those salesmen that I mentioned earlier were only selling enough insurance to get their clients in the ground while some of the more prestigious offices had insurance consultants that worked around their client’s financial budgets to get them the most insurance they could afford. This allowed wives whose husbands died at an early age to stay at home with the children rather than take on a low wage job or older spouses to pay off a mortgage and not sacrifice their lifestyle.
Today, many people are still buying arbitrary amounts of life insurance with no consideration of what they want the money to do once they pass away. There are two ways to look at how much life insurance is right for you – needs based or income replacement. Your face value will probably fall somewhere between these amounts once you take your budget into consideration.
- A needs based analysis involves you sitting down and thinking about what you would want to happen (financially) if you passed away tomorrow. Would you want your mortgage to be paid off? Would you want a college fund set up for your kids? Would you want to set up a monthly stipend for your spouse or the caretaker of your kids? Taking the time to create a plan is one way you can reduce the stress and burdens of those you care about.
- Another method to determine your insurance need is to use the income replacement approach. Simply take your annual after-tax income and multiply it by the number of years you have until retirement. This is the amount of income that your family would miss out on if you were to pass away tomorrow. You can subtract the amount that you spend on your personal expenses such as food, clothing and transportation but include one time expenses likes college tuition, debt payoffs and funeral expenses. In theory, the amount of your insurance need should decrease each year, but once you consider inflation and annual raises, the amount you choose today may be sufficient for future needs.
Often income replacement is not considered for non-working spouses but their contributions, although not always seen in the form of a paycheck, should not be underestimated. Imagine the value of a stay at home parent. You would either have to quit your job thereby having to replace your income or find someone to complete tasks like baby sitting until you get home, housekeeping, etc. which would increase your monthly expenses. Discuss the issue with your spouse then take some time to consider which approach you would take and its financial implications.
Generally, insurance benefits are received income tax-free. Imagine the relief that would be felt by your spouse or the caretaker of your children if they didn’t have to mourn your death and worry about finances. Planning for your demise may be a morbid thought but it is something that we all must face. Your money matters to those who depend on you for their care and livelihood, don’t let them down when they need you the most.