How Much Life Insurance Is Too Much?
Posted on January 26, 2021
by Don Shaughnessy
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People intuitively underestimate their life insurance needs. Almost always because the cannot calculate the amount of capital required to replace the income they now use for family purposes.
It is not an especially easy calculation. It relies on several facts that are easy enough to come up with, but how they play out in time is not so clear. There will be some assumptions.
Begin with learning what you can
- How much of your take home pay matters to the family? Suppose you earn $6,000 per month and after taxes, pension, Government plans, and union dues you bring home $4,000.
- How much life insurance do you own now and will it be retained. This will be decided when the insurance evaluation is completed. Be aware, group and credit insurance tends to be expensive.
- What assets now owned will be sold.
- How much is current cost of living. Simple terms it is usually take home pay less, debt payments and savings. What you pay on debt and set aside for the future is not cost of living. Some debt like car loans probably should be retained as cost of living because the asset they relate to will be replaced some day.
If there is a large sum of capital provided at death, how will it be used most effectively. The usual questions involve:
- Pay off debt like a mortgage
- Create education funding for the children
- Provide an emergency fund
- Provide for capital expenses. If you rent, you might want to purchase a house instead. Maybe a car purchase.
What will the economy look like
- Inflation affects how the family need for money changes over time
- Investment earnings will involve the tax rate that applies, the risk tolerance of the survivors, access to the need investments.
- Understand how marginal tax rates work
What other changes to cost of living will arise
- How much of current cost of living relates exclusively to the deceased? Consider food, work expenses, second vehicle, clothing, recreation, hobbies, personal care.
- What tasks the deceased performs now will be different or purchased in future? Consider maintenance, food preparation, shopping, and babysitting.
- Will daycare disappear someday?
- When will the children move out on their own? When they do, how does it affect cost of living? What changes in costs arise as they age? Teenagers are ore expensive than toddlers.
- What spontaneous income will appear. Canada Pension plan has a survivor benefit.
Collecting the ideas together.
Given there are several pieces to future needs, you will need to calculate the capital needed for each separately and add then together. You can test it by creating an amortization table base don your assumptions. Given that, you can test to see what happens if you are very wrong about your assumptions.
You have several pieces to consider.
- The immediate cost fund. Funeral, legal fees, maybe taxes, executor costs, income lost because of time off work for the survivor
- The cost of living fund
- The education fund
- The debt payment fund
- The capital acquisition fund
That will give you the total need.
From that total need you can deduct amounts that will be available:
- Commuted pension
- Retained life insurance
- Sale of personal assets
- Existing savings
- Potential inheritances
The net amount is the shortfall that should be solved with life insurance.
The answer will get a reaction
Number 1. Wow, that’s way too much! Most people don’t realize how much capital you need to produce even $1,000 a month after taxes for 20 years when invested in bank term deposits at 3% with inflation at 2% and taxes at 35%. That would be $236,000. More each month, or for longer creates larger amounts.
If you do the work, you can decide what of the assumptions and factors you want to change to get a smaller number.
Number 2. He or she will remarry. That’s possible, but do you want to force them to do so. Many (even a majority) people do not.
Number 3. I cannot afford that much. Product choice is a question unconnected to the need question. Find what the price will be. For example, For a 38-year-old female non-smoker, with “standard” health and other factors, $1,000,000 costs $390 per year from a major carrier.
- The whole thing is just a big arithmetic question. You can get a number and know why you have it. This kind of why motivates.
- Life insurance can fit into your budget.
- You can easily put it off. Remember “insurance poor” can relate to the payor or to the survivors. The payor has choices, the survivors will not.
I help people have more income and larger, more liquid estates.
Call or email firstname.lastname@example.org or in Canada 705-927-4770