Determining Your Life Insurance Needs
SEE ALSO >>> Estates & Trusts
What, if any, role life insurance should play in your financial plan depends on a variety of factors, such as whether you’re single or married, if you have minor children or other dependents, your net worth and your estate planning goals. If you decide that you do need coverage, you have to determine how much and what type of coverage will best help you achieve your goals.
Looking at your situation
Life insurance is appealing because relatively small payments now can produce a proportionately much larger payout at death. But the fact that the return on the investment generally isn’t realized until death can also be a downside, depending on your financial situation and goals.
If you have others depending on you financially, your No. 1 priority is likely ensuring that they will continue to be provided for after you’re gone. Life insurance can be a useful tool for achieving this goal.
If you’re single and have no dependents, life insurance may be less important or even unnecessary. Perhaps you’ll want just enough coverage so that your mortgage can be paid off and your home can pass unencumbered to the designate heir(s) — or just enough to pay your funeral expenses.
If your net worth is high, you may not need life insurance for any of the aforementioned purposes, but it might serve other purposes in your estate plan. For example, it can provide liquidity to pay estate taxes without having to sell assets that you want to keep in the family. Or it can be used to equalize inheritances for children who aren’t involved in a family business so that family business interests can go only to those active in the business.
Calculating the coverage
If you determine that you need life insurance, the next step is calculating how much you need.
If the coverage is to replace income and support your family, this starts with tallying the costs that would need to be covered, such as housing and transportation, child care, and education — and for how long. For many families, this will be only until the youngest children are on their own.
Next, identify income available to your family from Social Security, investments, retirement savings and any other sources. Insurance can help bridge any gaps between the expenses to be covered and the income available.
If you’re purchasing life insurance for another reason, the purpose will dictate how much you need:
Funeral costs. An average funeral bill can top $7,000. Gravesite costs typically add thousands more to this number.
Mortgage payoff. You’ll need coverage equal to the amount of your outstanding mortgage balance.
Estate planning. If the goal is to pay estate taxes, you’ll need to estimate your estate tax liability. If it’s to equalize inheritances, you’ll need to estimate the value of business interests going to each child active in your business and purchase enough coverage to provide equal inheritances to the inactive children.
Something else you’ll need to keep in mind is how taxes factor in. See the sidebar “The tax impact of life insurance.”
Term vs. permanent
The next question is what type of policy to purchase. Life insurance policies generally fall into two broad categories: term or permanent.
Term insurance is for a specific period of time. If you die during the policy’s term, it pays out to the beneficiaries you’ve named. If you don’t die during the term, it doesn’t pay out. It’s typically much less expensive than permanent life insurance, at least if purchased while you’re relatively young and healthy.
Permanent life insurance policies last until you die, so long as you’ve paid the premiums. Most permanent policies build up a cash value that you may be able to borrow against. Over time, the cash value also may reduce the premiums.
Because the premiums are typically higher for permanent insurance, you need to consider whether the extra cost is worth the benefits. It might not be if, for example, you may not require much life insurance after your children are grown.
But permanent life insurance may make sense if you’re concerned that you could become uninsurable, if you’re providing for special-needs children who will never be self-sufficient, or if the coverage is to pay estate taxes or equalize inheritances.
Fulfilling your goals
While no one likes to think about leaving loved ones behind, most people find some comfort in knowing their family’s financial needs will be covered and their estate planning goal will be fulfilled. A suitable life insurance policy can help.