Many financial experts consider life insurance to be the cornerstone
of sound financial planning. It can be an important tool in the
following situations:
Replace
income for dependents
If people depend on your income, life insurance can replace that
income for them if you die. The most commonly recognized case of
this is parents with young children. However, it can also apply
to couples in which the survivor would be financially stricken
by the income lost through the death of a partner, and to
dependent adults, such as parents, siblings or adult children
who continue to rely on you financially. Insurance to replace
your income can be especially useful if the government- or
employer-sponsored benefits of your surviving spouse or domestic
partner will be reduced after your death.
Pay final
expenses
Life insurance can pay your funeral and burial costs, probate
and other estate administration costs, debts and medical
expenses not covered by health insurance.
Create an
inheritance for your heirs
Even if you have no other assets to pass to your heirs, you can
create an inheritance by buying a life insurance policy and
naming them as beneficiaries.
Pay
“death” taxes
Life insurance benefits can pay estate taxes so that your heirs
will not have to liquidate other assets or take a smaller
inheritance. IE. Capital Gains Tax
Make
significant charitable contributions
By making a charity the beneficiary of your life insurance, you
can make a much larger contribution than if you donated the cash
equivalent of the policy’s premiums.
Create a source
of savings
Some types of life insurance create a cash value that, if not
paid out as a death benefit, can be borrowed or withdrawn on the
owner’s request. Since most people make paying their life
insurance policy premiums a high priority, buying a cash-value
type policy can create a kind of “forced” savings plan.
Furthermore, the interest credited is tax deferred (and tax
exempt if the money is paid as a death claim).
How much life insurance do I need?
In
most cases, if you have no dependents and have enough money to pay
your final expenses, you don’t need any life insurance.
If
you want to create an inheritance or make a charitable contribution,
buy enough life insurance to achieve those goals.
If
you have dependents, buy enough life insurance so that, when
combined with other sources of income, it will replace the income
you now generate for them, plus enough to offset any additional
expenses they will incur to replace services you provide (for a
simple example, if you do your own taxes, the survivors might have
to hire a professional tax preparer). Also, your family might need
extra money to make some changes after you die. For example, they
may want to relocate, or your spouse may need to go back to school
to be in a better position to help support the family.
You should also plan to replace “hidden income” that would be lost
at death. Hidden income is income that you receive through your
employment but that isn’t part of your gross wages. It includes
things like your employer’s subsidy of your health insurance
premium, the matching contribution to your Pension plan, and many
other “perks,” large and small. This is an often-overlooked
insurance need: the cost of replacing just your health insurance and
retirement contributions could be the equivalent of $400-$5000 per month
or more.
Of
course, you should also plan for expenses that arise at death. These
include the funeral costs, taxes and administrative costs associated
with “winding up” an estate and passing property to heirs. At a
minimum, plan for $15,000.
Other sources of income
Most families have some sources of post-death income besides life
insurance.
Many also have life insurance through an employer plan, and some
from another affiliation, such as through an association they belong
to or a credit card. If you have a vested pension benefit, it might
have a death component. Although these sources might provide a lot
of income, they rarely provide enough. And it probably isn’t wise to
count on death benefits that are connected with a particular job,
since you might die after switching to a different job, or while you
are unemployed.
A
multiple of salary?
Many pundits recommend buying life insurance equal to a multiple of
your salary. For example, one financial advice columnist recommends
buying insurance equal to 20 times your salary before taxes. The
number 20 was selected because, if the benefit is invested in bonds that pay 5
percent interest, it would produce an amount equal to your salary at
death, so the survivors could live off the interest and wouldn’t
have to “invade” the principal.
However, this simplistic formula implicitly assumes no inflation and
assumes that one could assemble a bond portfolio that, after
expenses, would provide a 5 percent interest stream every year. But
assuming inflation is 3 percent per year, the purchasing power of a
gross income of $50,000 would drop to about $38,300 in the 10th
year. To avoid this income drop-off, the survivors would have to
“invade” the principal each year. And if they did, they would run
out of money in the 16th year.
The “multiple of salary” approach also ignores other sources of
income, such as those mentioned previously.
A
simple example
Suppose a surviving spouse didn’t work and had two children, ages 4
and 1, in her care. Suppose her deceased husband earned $36,000 at
death but had no other death
benefits or life insurance. Assume the surviving spouse is 36.
Assume that the deceased spent $6,000 from income on his own living
expenses and the cost of working. Assume, for simplicity, that the
deceased performed services for the family (such as property
maintenance, income tax and other financial management, and
occasional child care) for which the survivors will need to pay
$6,000 per year. Assume that the survivors will have to buy health
insurance to replace the coverage the deceased had at work, and that
this will cost $3,000 per year.
Taken together, the survivors will need to replace the equivalent of
$39,000 of income, adjusted each year for an assumed 4 percent
inflation.
The life insurance amount needed today to provide the $39,000 annual amount is roughly $360,000. Adding $15,000 for
funeral and other final expenses brings the minimum life insurance
needed for the example to $375,000.
What’s left out?
The example leaves out some potentially significant unmet financial
needs, such as
The surviving
spouse will have no income from CPP from age 53
until 60 unless the deceased buys additional life insurance to
cover this period. It could be assumed that the surviving spouse
will obtain a job at or before this time, but she could also
become disabled or otherwise unable to work. If life insurance
were bought for this period, the additional amount of insurance
needed would be about $335,000.
Some people
like to plan to use life insurance to pay off the home mortgage
at the primary income earner’s death, so that the survivors are
less likely to face the threat of losing their home. If life
insurance were bought for this goal, the additional amount of
insurance needed is the amount of the unpaid balance on the
mortgage.
Some people
like to provide money to pay to send their children to
University or college
out of their life insurance. We may assume that each child will
attend a public school for four years and will need $15,000 per
year. However, school costs have been rising faster than
inflation for many decades, and this trend is unlikely to slow
down. If life insurance were bought for this goal, the
additional amount of insurance needed would be about $200,000.
In the example,
no money is planned for the surviving spouse’s retirement,
except for what the spouse would be entitled to receive from
CPP (about $1,200 per month). It could be assumed
that the surviving spouse will obtain a job and will either
participate in an employer’s retirement plan or save with an
RRSP, but he/she could also become disabled or otherwise unable to
work. If life insurance were bought to provide the equivalent of
$4000 per month starting at age 60 until 65 and $3,000 per month
from 65 on the additional amount of
insurance needed would be about $465,000.
