How Life Insurance Fits Into A Financial Plan
What’s the one thing that can instantly mean you won’t accomplish your family’s financial goals? It’s your untimely death. It’s the one risk that immediately pushes aside the retirement, college funding, home ownership, and any other plans you may have made for your family.
A financial plan without adequate life insurance is no financial plan at all.
If anyone else is relying on your income, and would be unable to pay their bills without your support, you need to have life insurance. That means parents of minor children, but also anyone financially supporting their parents, spouse or any other family member as well.
Finding the Right Insurance
Most people’s needs are met by a term life insurance policy. This is a policy that’s in force for a set period of time, or “term,” such as 20 or 30 years. The goal is to have term insurance up until either:
- No one is relying on your income anymore
- Or you’ve built up large enough financial assets that, in your absence, those assets could sufficiently support those who do rely on your income
Permanent life insurance is meant to cover a buyer for the entirety of their life, on the assumption there is an insurance need that won’t go away any time prior to their death. With few exceptions, such as those with a special needs child, the additional expenses associated with permanent life insurance make it not the ideal tool to meet a life insurance need.
How Much Life Insurance Do You Need?
You probably need more life insurance than you think. But since that answer is insufficient, let’s look at the different considerations that impact how much life insurance you need. Depending on many other factors in your financial plan, your insurance need changes, which is why going only by broad rules of thumb can lead to being significantly under or over insured.
Age: Broadly, if you have an insurance need, you will need more insurance when you are younger and less as you age. If you’re 33 and have two young children and a brand new mortgage, it’s likely you have a larger insurance need today than you will in a decade when the kids are older and much of your debt has been paid down. Of course, not everyone’s life follows that trajectory.
Debt: What debts do you have, and will they all need to be paid off by your death? Most debts must be settled by your estate, but most federal student loans do not. Thus, $100,000 in mortgage debt would need to be repaid either at death or over time, but $100,000 of most direct federal student loans would be discharged at death and your estate is not responsible for paying it off.
Family situation: How many kids you have, their ages, and what you hope to leave them all play into your life insurance calculation. Even if incomes are identical, someone with one child who is 14 needs less life insurance than someone with three children who are all under the age of seven. There are many more years of costs that must be met for a family with younger children.
In addition, the ratio of your income to your spouse’s income matters. If you earn 80% of the income in the household, your insurance need is likely greater than someone who earns 30% of the income for the household, even if your incomes are identical.
Financial goals: If you’re planning to fully fund your kids’ college education, you need more insurance than someone who does not include that on their list of financial goals.
Savings rate: Take two people who each earn $150,000 per year. Person A saves $30,000, and spends (including taxes) the other $120,000. Person B saves $10,000, and spends (includes taxes) the other $140,000. Person A has a lower insurance need both because they spend less money each year and because they will have accumulated more assets than person B, due to their higher savings rate.
This may lead to only very small differences in the short run, but compounded over a decade or several decades, the insurance needs are vastly different.
Burial Costs: For most people this is a smaller part of the overall need, but should be factored in as well. If you intend to be cremated, your end-of-life expenses are likely less than someone with a burial wish. The average costs for a funeral with burial and vault is just over $9,000, according to the National Funeral Directors Association.
Other current financial obligations: A terrible irony is that often those who have significant life insurance needs are those least able to afford the monthly premiums to adequately insure their lives.
If your budget is tight month to month, and you’re working to pay down debt and accumulate retirement savings on a limited income, you may end up opting for a smaller insurance amount than your circumstances require. The tradeoff is one many are forced to make.
Life insurance needs often decline over time, so the amount of insurance you need now will be far greater than you might need in 15 to 20 years. A life insurance ladder can help you build an insurance plan that adapts to your changing financial circumstances. You can either increase coverage if necessary, or allow your insurance coverage to taper off over time so that you don’t pay a premium each month for insurance that is far beyond your need by the time you pass away.
Factoring In Workplace Life Insurance
Since most of us may leave our employer at some point, your life insurance should not be wholly tied to the employer. Purchasing at least some level of life insurance individually ensures you’ll have something in place if you unexpectedly lose your job.
While some employer policies have a portability feature that allows you to take the coverage with you when leaving the job, you may end up getting repriced. If you are much older or have had a major health event since the insurance began, the premium could significantly increase for the same amount of insurance.
A level premium term life policy locks in a set price for the duration of the term, eliminating the risk of being priced out of a policy.
Employer life insurance can often work well in conjunction with an individual policy to create the insurance ladder noted above. Let’s look at the following example:
Life insurance need: $1,000,000
Existing individual term life insurance: $500,000
Employer provided insurance: 1x salary (in this case, $100,000)
Between the life insurance need and existing insurance, there’s a gap of $400,000. While it’s ideal to have an individual policy for that amount, it’s often far easier to sign up via your employer, so many people do so. By signing up for 4x salary ($400,000), this person now has their full insurance needs met (assuming they don’t lose the workplace coverage).
If insurance needs decline over time, you can adjust their workplace life insurance downwards each year.
Another consideration to having at least some life insurance individually, and not via an employer, is that once in place, you’ve preserved your insurability. If you attempt to get life insurance after a major health event, such as a heart attack, most insurance companies will either reject the application or charge an exorbitant premium.
Everyone’s financial plan is different, and few plans stay static for long. Continually reviewing your financial plan and adjusting your life insurance lets you ensure you’re adequately covered, but also that you’re not paying for more insurance than you truly require.