3 Things To Know About Life Insurance Needs

When you’re in the market for buying life insurance, one of the first questions you ask yourself is how much is this going to cost. Well, that all depends doesn’t it. It’s a factor of a few main variables:

  1. How much life insurance do you need
  2. How old are you – age matters
  3. Do you smoke – yes smokers have to pay more, but it’s a lifestyle choice that costs lots of money in many ways
  4. How is your health? Good, average, bad – cheaper, standard price, extra premium.

In this article we will discuss the first point, ”How much life insurance do you need”. When making the basic analysis of your insurance needs a good Life Insurance Advisor will take you through what is often called a Financial Needs Analysis. This is a calculation, using simple math, of how much tax free income your beneficiaries would need if you died tomorrow.

Step 1 – What do you have?

The first part of the analysis should look at the assets you have today. This would include any existing insurance policies, cash savings, equity in property that could be sold, etc.  It is important to note that not ALL your assets are liquid, and even if they are, not all of them should be earmarked for emergency spending.  Here are some things to think about before including your assets in this analysis.

  • ·         If you have retirement savings, especially tax sheltered savings like a 401K in the US or an RRSP in Canada, would you want that money liquidated at death and used as emergency cash for your family? Your spouse could really use that money for his/her retirement plans, and if liquidated there would be a lot of taxes owning on your accumulated savings. Taxes could reduce your nest egg savings by 25 – 35%! It’s best to keep retirement savings intact for your spouse, and buy a little extra life insurance to protect it.
  • ·         Are you thinking you could get equity out of the house for an emergency? Well, this would typically mean selling the house. If you sell, where will the surviving family live? Will they be forced to downsize or become renters because there was not enough life insurance? What standard of living do you want to provide for your family if tragedy struck? If living in your family house means stability for your spouse and children, then keep them there – don’t force them into moving homes if you died.
  • ·         Business assets and other real estate. What will you do with these? If your spouse is not going to take over your business, or wants to run rental properties, etc. then you need to plan on selling them if you were to die. Be conservative here. If the housing and/or business market is booming the price you could get for your business today might look very good. In a few short months things can change rapidly and you could see a major housing price drop or local business activity dry up. What will your assets be worth then? Plan for a realistic and somewhat conservative number when valuing your business and real estate assets, and take brokerage fees into account for making the sale for your survivors.
  • ·         What will happen to cash savings that are set aside to achieve a certain goal? If you’re saving now for things like a cottage/vacation property, would that dream still be on the table if something happened to you? Would your spouse and kids still want to have that vacation home at the lake? Decide if this is a luxury or something worth insuring.

Step 2 – Immediate cash needs

 The next step is to determine the immediate amount of cash your family would need over the first 6 to 12 months to get their affairs in order. This is called the Immediate Cash Needs, and covers the following areas:

  • ·         Final expenses – this includes funeral costs, legal and executor fees, and any other closing costs to your estate. For most families this is rather simple, and a number of $15 – $20 thousand should be planned for. If you have a large estate, plan for 3-4% of your total assets being eaten up by these final expenses.
  • ·         Paying off the mortgage – make sure that major debts like your mortgage are paid off. Have enough life insurance in your plan so that your spouse can decide whether or not to pay off the mortgage or invest the money. Life insurance, unlike mortgage insurance, gives the tax free cash to your spouse to do with as he/she wants. If interest rates are presently higher than your current mortgage rate, then it would be wise to invest the money and keep paying down the mortgage. At renewal, when the bank wants to increase your rates, you can then pay it off.
  • ·         Other loans and debts – if you have a business loan, family line of credit, student loans, etc., make sure these are all paid off in the event of your death.
  • ·         Education funding for children – many parents are trying very hard to save for their kids’ future education. It can be very hard to save the money each month, but if you’re doing it then you know it’s important. Even if you currently can’t afford to save the money each month for your kids, wouldn’t you like to know that if you died, there would be enough money paid out by the life insurance company to send your kids to college/university? Plan on at least $40,000 per child for education funding in your life insurance plan.
  • ·         Replacing a stay at home parent – if one of the parents stays home to take care of the children, there is still a very high cost to losing this household contributor. The cost of bringing in a home worker or live in nanny is huge – $1,500 – $2,000 per month (that would usually include room and boarding costs). Could the income earning spouse still do his/her job without someone home to look after the kids? With small children at home the cost to replace the unpaid work of the stay at home parent could run as high as $250,000 over 10 years. Think about putting a child care number into your insurance plan.

Step 3 – Replacing lost income

For many people, they think their most valuable asset is their house. It could be worth $300, $400, $500 thousand dollars or more. Even if you are still paying your mortgage, the equity in the house and the size of that asset seems like it the biggest thing in your life. Actually, the most valuable thing you own today is YOU. Think of yourself as an economic engine for your family. You can work, earn an income, and churn out money for many years to come. How much would your family lose if you died tomorrow? Here is an example of long-term economic loss:

If you were 40 years old today, making $75,000 per year, and you worked until you were 65, you will make $1,875,000 over the next 25 years. But wait, it isn’t that simple. There’s inflation, investment returns,  and salary increases to budget for.  If you expected to have average salary income increases of 2% per year for the rest of your working career (keeping up with inflation) and your lump sum capital could make 5% interest over the next 25 years, how much money would you need today to generate the lost $75,000 of income? The answer is $1,280,000 of tax free life insurance proceeds now to replace your lost income over time.

The insurance calculation can be a little more complex than that, based on your wishes. Do you want to replace your entire life’s income potential for your spouse, or would you want to make sure the children are raised and then your spouse can downsize and return to the working world? These are things to think through with your life insurance advisor when doing the financial needs analysis.

Step 4 – Final Result

The final result for the Financial Needs Analysis is your total life insurance need. It is a quick plus minus calculation.

Immediate Cash Needs + Replacing Lost Income – What You Have Now = Total Life Insurance Need

This is the amount of life insurance your advisor should be recommending you buy. Less would mean you are under-insured, and then the advisor has not done their job. More insurance and you would be over insured and paying premiums for insurance that is excess.

Be sure to ask your life insurance advisor to complete a financial needs analysis with you. If they can’t, don’t know how, or want to just pick an amount of insurance out of the air, get another advisor. You can and should get more qualified advice when making an important decision like how much life insurance to but for your family.

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