For many people, particularly those with young families, their greatest asset is likely their ability to earn an income in the future. This makes life insurance one of the most important parts of their financial plan. We insure our house against fires and floods and our cars against collisions, so why wouldn’t we insure our greatest asset? Often it’s because there are too many decisions to make and few objective partners to provide commission-free advice. So, if you’re having trouble determining how much life insurance you need, what type, and for how long, this series will be a great place to start.
The purpose of life insurance is very simple: it is there to replace your income for your dependents after you pass. A life insurance policy is a contract between you and the insurance company. You pay premiums for the defined length of time, and the insurance company promises to pay a death benefit to your beneficiary if you die while the policy is active. However, if you don’t pay the premiums, the insurance company may not be obligated to pay the death benefit!
There are four main parties to a life insurance policy:
- The insurer is the insurance company that pays out the death benefit.
- The owner is the person responsible for paying the premiums to the insurance company.
- The policy is based upon the insured’s life.
- The beneficiary is the person or entity that receives the death benefit after the insured passes away.
One of the hardest things to figure out with life insurance is which policy you need because there are so many choices! The following types of life insurance are the most common policies offered.
Term Life Insurance
Term insurance is the most inexpensive and straightforward form of life insurance. The term is a fixed period, say 10 or 20 years, in which you pay your premiums in exchange for death-benefit coverage. If you die within the term period, the insurance company pays the death benefit to your beneficiary. If you don’t die within the term period, the policy expires. A good way to think about term life insurance is by comparing it to your auto insurance. You pay premiums for your auto insurance in case you get into an accident. If you don’t get into an accident, you don’t get the premiums back. This concept is the same for term life insurance. Yes, you never receive a benefit from this policy if the term expires. But hey, at least you’re alive! A few good examples of when term life insurance makes sense are in cases of temporary needs such as:
- Affordable coverage during your earning years
- Covering specific large expenses such as your children’s education or your mortgage
- Covering your funeral costs and other final expenses
But sometimes you need coverage that goes beyond your earning years, and sometimes people realize they would rather not pay into a policy that expires. That’s where permanent life insurance might be a better option.
Permanent Life Insurance
Permanent insurance, which is much more complex than term insurance, can function not only as an insurance expense but as an asset as well. The main difference from term insurance is that permanent insurance has a “cash value” component and the death benefit doesn’t expire. While the premiums are required for the rest of your life, the cash value can help offset some or all of this insurance cost if it has enough time to accumulate. Some examples of when permanent life insurance makes sense are in cases of permanent needs such as:
- Offsetting a decrease in pension income from an early death in retirement
- Legacy planning, when it comes to transferring wealth across generations
- Estate planning, so that you’re providing liquidity to an illiquid estate or covering taxes from a sizable estate
There are various forms of permanent life insurance to consider—whole life, universal life, and variable universal life insurance.
Whole Life Insurance
Whole life insurance is considered the “original” permanent life insurance whereby the policy is in place for your entire life. The premiums for a whole life policy are fixed for the entire length of the policy, so as long as they are paid, they will not increase as you age. When paying premiums to your whole life policy, part goes towards covering the actual cost of insurance and part goes into the cash value savings component. This can explain the cost difference when comparing with term insurance!
Universal Life Insurance
Universal life insurance is very similar to Whole Life except that your premiums and death benefit can be more flexible, and you can adjust them if you need to. When adjusting your premiums, you are essentially using some of your cash value to make your payment lower. If an unexpected financial need arises you can temporarily stop your premium payments and make up the difference later when things are back to normal.
Variable Universal Life Insurance
This is where we start seeing much more complexity because in addition to the insurance piece and savings component, variable universal life allows for you to decide how your cash value is invested. While this may seem like a bonus, the investment risk is now completely on you, not the insurance company.
How Much Life Insurance Do You Need?
Now that you know more about the various types of life insurance policies offered, along with when each type of policy would make sense in your life, you should have a better idea of which type meets your needs. So you’re probably wondering how much life insurance you need.
Here’s where to start when you’re estimated your life insurance needs.
Human Life Value Approach
One simple and easy way to estimate how much life insurance you need is by using the Human Life Value Approach. With this approach, you multiply your annual salary by a multiple, most commonly 6 through 10. The multiple you choose should depend on your age and the number of years left your family would be dependent on your income.
For example, if you are younger, you will want a multiple closer to 10 because you will need to replace your income for a longer period of time should you pass away unexpectedly. On the other hand, if you are an older individual, you will want a multiple lower than 10 because the number of years you will need to replace your income for your dependents will most likely be smaller.
While this method is a good starting point to determining how much life insurance you need, it isn’t completely accurate because it doesn’t consider factors such as inflation, the changing economy, or major expenses.
A more thorough way of determining your life insurance needs is by using the DIME formula. The DIME formula takes into account various factors that the Human Life Value Approach does not. The DIME method looks at your debts and final expenses, income, mortgage, and children’s education.
Debts and Final Expenses
The first step of the DIME formula is to add up all of your current debt such as your credit card debt, student loans, and car loans. When you die, your debt doesn’t disappear; it passes right to your heirs! Accounting for your debt and including it in your life insurance death benefit will allow for your dependents to have the funds to pay it off, rather than being stuck with it. You will also want to include the expenses for your funeral, which can be pretty costly; funeral costs can fall between $7,000 and $10,000. This lifts a huge burden off your family’s shoulders when planning your funeral arrangements.
The next step in the DIME formula is to multiply your annual income by the number of years you think that your dependents would need your financial support. For example, if you have dependent children, you typically need to provide financial support until the youngest child turns 18 years old.
Another liability that you should account for is your mortgage. If you are still paying a mortgage, your life insurance benefit should include the funds needed to pay off the remaining balance on the policy.
If you have children and want to pay for their college education, you should budget for that in your life insurance policy. The typical rule of thumb is to allocate $100,000 per child for a four-year university at a state school.
After adding up all of these factors, the DIME Method provides you with an estimated life insurance need. Again, this method still does not account for inflation or the changing economy, but it does give you a great starting point for determining how much life insurance you need.
Everyone’s life insurance needs are different, so feel free to reach out to us if you have any questions regarding life insurance in your financial plan.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.