Financial Advice for Retirement, Social Security, IRAs and Estate Planning

The Most Common Insurance Mistake

Published on: May 01 2000
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Following rules of thumb can be dangerous to your wealth. Yet rules of thumb are the way many people decide how much life insurance to purchase. That’s why most people have either too much or too little life insurance.

It’s one of the major financial mistakes. Buy too much life insurance, and you are wasting money. Buy too little and your family is exposed to risks and losses they cannot handle.

A frequently-cited rule of thumb is that you should carry life insurance equal to a multiple of your annual income. That multiple varies from 5 to 10 times your income, depending on whom you ask. The most common rule of thumb I hear is that you should carry about seven times your annual income.

But your life insurance needs have little or nothing to do with your annual income. If you are older, have a high annual income, have accumulated a lot of assets, and have few or no dependents. Under those circumstances, you might not need any life insurance. You will leave behind enough assets to pay your debts and taxes and care for the few loved ones who are dependent on you.

But suppose you earn the same income but are younger, have several dependents, and have not yet accumulated significant assets. Then you might need a fair amount of life insurance. You might need more than five times your annual income.

That’s an example of how two people with the same income have very different life insurance needs.

Life insurance should be to cover specific needs or expenses or meet certain goals. That’s your starting point for deciding how much life insurance to carry.

Begin with the annual expenses that will need to be covered after you are gone. For example, if your spouse depends at least partly on your income, list the annual living expenses of the household. Try to estimate how much those expenses are likely to decline after you are not in the household.

Then, subtract the other income that will be available cover those expenses. Your spouse might work, or you might assume he or she would go back to work. There might be annuities, Social Security Survivors’ benefits, or employer payouts. If you will leave behind investment assets or retirement accounts, decide if you want these to be tapped to replace your income. Then you estimate how much income or distributions these assets can generate each year.

The difference between the expenses and the available income is the amount that should be covered by life insurance. How do you convert this annual income into the amount of insurance to buy?

There are a couple of easy ways to do that. First, estimate a rate of return the insurance benefit is likely to earn when invested. Then you have two choices. One choice is to assume the principle is not touched. In that case, simply divide the annual income needed by the estimated rate of return. The result is the amount of insurance to buy.

Suppose you want to replace $30,000 of income and expect the life insurance will be invested to earn 7%. Divide $30,000 by 7%, and you will need about $430,000 of insurance.

The other method is to assume that part of the principal will be spent each year. Then you’ll need annuity tables or an annuity calculator. Estimate the number of years you want the income to last and the rate of return. The calculator or tables will tell you how much life insurance to buy. For example, if you want to pay $30,000 annually for 30 years and expect the fund to earn 7%, you’ll need about $375,000 of insurance.

A third option is to assume the beneficiary will buy an annuity with the insurance. Determine how much an appropriate annuity would cost today, and buy the right amount of insurance.

But that’s not the end of your insurance need. There might be lump sum expenses such education for the children or grandchildren. There are expenses related to your death, such as funeral expenses, estate taxes, and debt repayment. You also might want to make charitable bequests. Each of these expenditures must be covered by life insurance or by assets you leave. Total the expenditures to decide how much life insurance you’ll need.

Now, there is one more step to take. You must decide whether to buy term life insurance or permanent life insurance. Permanent insurance includes whole life, variable life, universal life, and survivorship or joint life insurance.

Term insurance is for needs that will end at a point in time, such as a child’s education or a mortgage. For these expenses, buy term insurance that will end when the need ends.
Permanent insurance is for spending needs that aren’t likely to end. Estate taxes are a good example. Gifts to charity are another example.

The living expenses of your surviving spouse fall somewhere in between. Over time you might accumulate enough assets to provide for your spouse without the a life insurance supplement. If so, you might want to buy term insurance that will end when you believe such a sum will be accumulated. Or you might want to split this coverage between permanent and term insurance.

An additional reason to consider buying life insurance is to increase the inheritance of your heirs. I’ve covered these strategies in past visits and special reports.

Once you have determined how much life insurance you’ll need and determined that amount into temporary and permanent insurance needs, it finally is time to go insurance shopping. A web site that can only determine your life insurance needs is www.life-line.org. Many other web sites help calculate life insurance needs. But most use the old multiple of income method.

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