Financial Fiddler

Have you watched the news and seen the terrible accidents and tragedies that happen every single day?  We have all seen and heard of devastating stories like a young husband and father who dies suddenly or a mother of three who is diagnosed with terminal cancer and has less than a month to live.  No one likes to think about death, but life insurance is one of the most important types of insurance to protect you and your family in the event of your death.  

What is Life Insurance?

When it comes to life insurance, numerous questions typically come to mind.  What is it? Who needs it? Are there different types? How much do I need? Life insurance is a contract between you and an insurance company.  You pay a monthly or annual payment, known as a premium, in exchange for a pre-determined amount of money. Having life insurance in place can give you peace of mind in case something were ever to happen to you.  

Reasons You Need Life Insurance

Everybody’s situation and priorities are different, no matter what stage of life you are in.  Remember that life insurance is not for you, but rather for your loved ones that depend on you if you were to pass away.  Here are some of the main reasons why you should consider life insurance.

1. Replace Primary Income

If you are the primary income earner in your family, imagine if that income were to stop suddenly.  How would the bills get paid? Would your family be able to maintain their same standard of living? Chances are they would not be able to keep going without your income.  Your ability to earn an income is one of the most valuable assets you provide your family.  

It does not matter if you are a family of two or ten.  If other loved ones rely on your income and it stops, it is necessary to replace that income by having life insurance.  Allowing your family to grieve your death and not worry about where the next dollar is coming from to pay a bill is one of the best gifts you can give them. 

2. Cover Cost of Spouse’s Income and Contributions

If you have a spouse who works and passes away, it is necessary to take into account their income contributions to your bills, debt and savings.  Even if they are not the primary income earner, their income is still vital in maintaining your same standard of living. 

If you have a stay at home spouse, they contribute more to your household than you could ever imagine.  They cook, clean, shop for groceries, care for children or pets if you have any, among endless other contributions.  If they were to pass away, the last thing you would want is to have to do all of this on your own, along with still having a career.  You would probably have to hire some help and find childcare, which is very expensive. 

3. Pay off Debt

Take a quick look at your current debt situation.  Maybe you have a mortgage, car payments, student loans, credit cards or other debts.  If you were to die, all your debts would still need to get paid somehow. If you have life insurance, you can plan to have some of your proceeds go to eliminate your debts so your family will no longer have to worry about them.  This could also save your family from having to go further into debt and even potentially losing their home and all the assets that you have built up. 

4. Fund Children’s Expenses

Raising children is very expensive nowadays.  Not only do you have to plan for college education, but you also have to cover other activities that your children are involved with, including: sports, tutoring, music, medical costs, educational fees and many other costs.  If they are not school age yet, you will likely have to pay for childcare as well. Life insurance proceeds can help cover these large expenses.  

5. Cover Final Expenses

Not only will your family have to worry about covering funeral costs, but did you realize that many times there are outstanding medical bills that still need paid?  According to the National Funeral Directors Association (NFDA), the average funeral today costs between $7,000-9,000.  This is just the average and depending on where you live, your funeral costs could be far higher.

Having life insurance will help cover your final expenses so your family does not have to.  They can focus on grieving your loss and learning how to keep on going without you. 

Reasons You Do Not Need Life Insurance

I mentioned many reasons why you need life insurance, but there are also several reasons why you do not need life insurance.  Again, it all depends on your situation and stage in life. Here are some of the main reasons why you do not need life insurance.

1. You’re Financially Independent

Basically, this means that you and your partner have reached a point that if something were to happen to either one, you have saved up enough income and resources in order to continue living your current lifestyle and maintain it for the rest of your life.

Sometimes, individuals who have an extremely high net worth will consider getting a life insurance policy in order to cover estate taxes.  Once you hit a certain limit, the IRS will tax your estate heavily and life insurance proceeds can help to cover that bill.   

2. No One Relies on Your Income

If you are single and no one relies on your income, you may not need to get life insurance.  Sure, people will mourn your death, but no one is relying on your income in order to continue living.  

3. You’re Children are Grown and You’re Retired

You may be young and have a family right now so loss of income could be devastating to your family.  But as life goes on, your kids grow up, graduate college, move out and start their own families. In the meantime, you and your spouse work on paying off your mortgage and debts and save plenty for retirement.  You eventually retire and if you were to pass away, loss of income would no longer be devastating for your spouse and family so the need for life insurance is no longer there.

Life Insurance Basics

I discussed some of the reasons why you should or should not get life insurance.  When it comes to life insurance, there are five main features that every policy has, no matter what type you buy, which include: Policyholder, Insured, Beneficiary, Death Benefit and Premium.   

• Policyholder.  This is the owner of the policy.  They are responsible for paying for the policy and keeping it in force.  They get to make all of the decisions related to the policy.

• Insured.  This is the person whose life is insured in the policy.  This could be the policyholder or someone else.

• Beneficiary.  This is the person, people or institution who receives the money when the insured person dies.  

• Death Benefit.  This is the money that is paid out when the insured dies.

• Premium.  This is the money paid monthly, quarterly, semi-annually or annually that keeps the life insurance policy in force.

For example, a husband might purchase a life insurance policy on his own life and he is both the policyholder and the insured.  He names his spouse and children as the beneficiaries for the death benefit.  

Another example is that same husband purchases life insurance on his spouse and names himself as the beneficiary for the death benefit.  He is the policyholder and beneficiary and his spouse is the insured. 

Types of Life Insurance

Life insurance is complicated to begin with and then there are the numerous types of life insurance that are available to most people.  Trying to pick life insurance can be overwhelming and confusing. I am going to dive into the main types of life insurance that you typically see nowadays.

1. Term Life Insurance

A term life insurance policy covers a set amount of time, or “term”, and then expires.  If you still need coverage after your term policy expires or is about to expires, you can buy a new policy or renew the old one.  Most term life insurance policies last anywhere from 5-40 years depending on the term.  

Term life insurance only pays out a death benefit if the insured person dies.  As long as premiums are paid-up, your beneficiaries will receive the face value of the death benefit.  For example, John has a $150,000, 20-year term life policy. He unfortunately dies suddenly sometime within his 20-year term.  His beneficiaries are paid his death benefit of $150,000.  

If your “term” runs out and you need to renew your insurance, you may have to prove your insurability again, depending on the company you are insured with.  This is why it is very important to read closely your policy and terms of agreement. Here are some of the most common types of term insurance that are available to most people.

• Level Term Insurance.  This is probably one of the most common forms of term life insurance.  Your premium stays “level” during your entire insurance term which could be 10, 20, 30 and sometimes even 40 years.  If you pay a premium of $50 a month in year one, you pay the same premium no matter what for as long as your term is.  

• Annual Renewable Term Insurance.  This type of term insurance only lasts a year and then requires you to renew if you still need insurance.  It is typically a cheaper option in the beginning as compared to level term, but each time you renew, your premiums also increase.  

• Decreasing Term Insurance.  This type of term insurance lasts a certain number of years and you pay a level premium, but the death benefit decreases over time.  You typically see this type of insurance if you are covering something like a mortgage.  

• Increasing Term Insurance.  This type of term insurance also lasts a certain number of years and both your premium and death benefit increase each year.  With this type of policy, you do not have to medically requalify every year that your death benefit is increased.  

• Convertible Term Insurance.  Many types of term insurance policies come with the option to convert the policy to permanent insurance if you do it within a certain timeframe.  Many times you do not have to show proof of insurability when you convert.  

2. Permanent Life Insurance

A permanent life insurance policy covers you for your entire life.  Because it has a cash value component, it is far more complicated and expensive than term life insurance.  As long as you pay your premiums, your beneficiaries will receive the death benefit when you die. 

When it comes to understanding how permanent life insurance works, your premium pays for both insurance and a savings account within your policy, also known as the cash value.  The cash value typically builds over time and grows tax-deferred. Depending on your policy, you may be able to borrow against the cash value and pay it back in increments. If you do not pay it back, the amount could get deducted from your death benefit.

If you surrender your permanent life insurance policy, you will receive your policy’s cash value minus fees from your insurance company.  Most permanent life insurance policies have very high surrender fees. Here are some common types of permanent life insurance.

• Whole Life Insurance.  This type of permanent insurance has fixed premiums and accumulates a cash value.  Insurance companies offer a variety of ways to pay your premium. Since your cash value is separate from the death benefit, if you were to die, your beneficiaries will typically receive only the death benefit and not the cash value.  Your insurance company would keep it. There are times where your cash value grows high enough that you can begin using it to pay your premiums.    

• Variable Life Insurance.  This type of permanent insurance allows the policyholder to put their cash value into an investment account that is managed by the insurance company.  If the investment does well in the account, the earnings can be used toward premiums or added to the death benefit. If the investment does poorly, you could wind up losing the majority of your cash value. This type of policy offers either a level death benefit or a face amount plus cash value death benefit, which typically costs much more.  

• Universal Life Insurance.  This type of permanent life insurance allows more flexibility with both your premiums and death benefit.  Your cash value is not guaranteed and has an investment component. You do not get to choose how the cash value is invested.  If you can afford it, you can pay more premium now and more goes into the investment account. There may come a time where finances are tight and you can use your investment account to pay the premium.  

• Variable Universal Life Insurance.  This is probably one of the most complex types of permanent life insurance.  It combines aspects from both Variable and Universal life policies. A variable universal life policy allows the policyholder to increase and decrease the death benefit.  It also offers the policyholder the freedom to determine how they want to invest their cash value, whether it is conservative or aggressive.

3. Group Life Insurance

Group life insurance is typically offered by your employer or other large-scale organization.  This type of life insurance is usually inexpensive and can sometimes be free, depending on your employer.  It works like an individual policy, with the employer being the owner of the policy. The typical group life policy is a term policy. 

Convenience, price and overall acceptance are three of the main reasons why people choose to get group life insurance.  Getting coverage from your employer is generally a simple process and the price is usually minimal. Many times, your employer will offer you a set amount of coverage like $50,000 or one or two times your annual salary at no cost to you.  If you want additional coverage, you cover it at a minimal cost.  

Getting coverage by group life insurance typically does not require a medical exam, unless you are purchasing additional coverage.  Even then, many employers allow you to answer a medical questionnaire versus having you get an exam. This is a pro, especially if you have any health issues that could prevent you from qualifying for an individual life insurance policy.

There are a few disadvantages to group life insurance.  Probably the main disadvantage is the fact that you cannot take the coverage with you if you leave your company or organization.  Some companies allow you to convert your group life to an individual policy if you leave, but you will pay a higher premium. Also, you are usually limited on the amount of insurance you can buy and if you need more, you are not able to get it through your group life insurance.  

How Much Life Insurance Do I Need?

There are numerous factors in determining the answer to this question.  It will come down to your priorities and how much you want to leave your family and those left behind in the event of your death.  A good general rule to start is to take your income and multiply it by 10-12 times. You then add your final expenses, debt, children’s expenses and any other miscellaneous expenses you would like covered.  Here are a few examples of how to calculate the amount of coverage you need.

1. Example 1: John, a working husband with 2 children and a spouse

John is the primary income in his family and earns around $60,000 per year.  He has a spouse and two younger children that he would like to take care of in the event of his death.  He wants their debts and his final expenses paid for along with funding the children’s college education and expenses.  His calculation would look like:

• $600,000 / $720,000 – 10-12 times annual salary
• $15,000 – Final expenses
• $200,000 – Outstanding debt, including the mortgage
• $100,000 – Education and expenses for both children

Total Insurance Need for John: $915,000 – $1,035,000

If John were to pass away, loss of income would be devastating for his family, which is why he needs such a large amount of life insurance.  

2. Example 2: Dave, a working husband with a working spouse and no children

Dave and his spouse are both working and earning around $70,000 per year.  If Dave was to pass away, he wants his final expenses and their outstanding debt paid for.  Also, since his spouse does not rely on his income to pay bills, he only wants his income replaced for a few years to give his spouse time to grieve.  His calculation would look like:

• $140,000 – 2 times annual salary
• $15,000 – Final expenses
• $100,000 – Outstanding debt including the mortgage

Total Insurance Need for Dave: $255,000

Since Dave’s spouse does not rely heavily on his income and since he does not have children, his insurance need is much lower than the first example.  

3. Example 3: Samantha, a stay-at-home mom with 2 young children

Samantha is a stay-at-home mom who cares for two young children.  Her spouse works and is able to support her and the two children. Even though Samantha does not have an annual income, she still contributes numerous services to her household.  If she were to pass away, she wants her final expenses and children taken care of until they are adults. Her calculation would look like:

• $250,000 / $400,000 – $25,000-40,000 average annual expense cost for 10 years
• $15,000 – Final expenses

Total Insurance Need for Samantha: $265,000 – $415,000

It is extremely difficult to calculate just how much a stay-at-home parent really contributes to their households.  Stay-at-home parents provide cleaning, childcare, meal preparation and a host of other non-compensated services. The surviving spouse would have to find a way to cover these services, typically by hiring outside help.  According to salary.com, they estimate that a stay-at-home mom salary should be valued around $162,581 annually.

Summary

Everybody’s situation is different when it comes to determining how much life insurance you need.  There are so many types of life insurance that the choices can be overwhelming. When you are determining which life insurance is right for you, start with prioritizing what needs you want covered and the cost.  From there, you can start to narrow down the type you want and how it will benefit you and your family.