Discussing life insurance is hardly a welcome pastime! Insurance terms are foreign, projections are hard to understand, and contemplating death is unpleasant. Evaluating insurance is central to your family’s long-term financial safety.
The first and most important question to answer is “what is the right amount of insurance?”
One simple way to calculate the amount of insurance needed is to take your salary (plus bonus, stock options/restricted stock) less an estimate of federal, state and FICA taxes you pay, times the number of years you expect to work. Be pessimistic about when you can afford to retire.
This simple calculation will give you a starting point. It does not take into consideration the time value of money, any Social Security family benefits or increases in compensation. This amount will replace your current income in the event of your death, but it won’t be enough to pay for college or payoff your mortgage.
The next question relates to what type of insurance product to use: term or permanent. To answer this question, begin by asking: How long will you need insurance?
For many, the answer will be until retirement or until the youngest child is self-supporting. Your need for insurance will be highest early in your career (with many years of future earnings ahead of you). As you age, this need will gradually decline.
Term: provides protection for a specific period of time (the “term”) and pays a death benefit only if you die during the term. Premiums rise with age, except Level Term, where premiums are set for a specified number of years.
Cash Value or Permanent Insurance: Also known as Whole Life, Variable Life, Universal Life, this provides protection and tax-sheltered savings in one product. Investment options vary with product.
The length of time you need insurance will dictate whether term insurance will be affordable.
Term insurance is the lowest cost, simplest product, but it becomes very costly as you age. Simply put, when you expect to need insurance beyond age 60, you will need to consider an alternative to annual renewable term insurance.
Level term is attractive from a budgeting standpoint, because the cost is level for the specified term. One strategy is to buy several level term policies with different terms.
For example, Susan needs $3.5 M of insurance at 50, but only $1.5M at 60. She might buy $2M 10 year level term and $750,000 each of 15 and 20 year level term. Alternatively, if your carrier allows a reduction in death benefit, you could buy one policy and step the death benefit down as needs decrease.
HOW DO YOU EVALUATE WHAT YOU HAVE?
Begin by understanding what type of policy you have, the death benefit, and what premiums you are paying. If you have a permanent policy, understand the cash value balance and your cost basis (you’ll pay tax on the amount above your basis if you exit) and how long you must continue to pay premiums.
SOME LAST CONSIDERATIONS
- Old policies may warrant a review. Why? They may be based on old actuarial tables, and with longevity on the rise, insurance rates have dropped. If you are still in good health, replacement may be an option, but avoid buying a new policy with surrender charges.
- All term insurance is not the same. Some term policies lack convertibility, a provision that allows a term policy to be converted to a permanent one when the term ends. If your conversion option is past and you are in good health, you might want to investigate the cost of moving to a fully convertible policy.
- Level term may be a good idea when you want to lock in the cost of your insurance coverage for a fixed period of time, but not your lifetime.
- If you are over 55, and you have group insurance that you don’t pay for, you may be paying more than you think, via imputed income tax. Any insurance coverage over $50,000 is considered taxable and included on your W-2 creating extra taxable income.
- Tax-free exchanges. Don’t forget that you can exchange the cash value in a life policy to an annuity in a tax-free exchange. This may be a good idea for permanent policies you no longer need.
It’s important to review your insurance on a regular basis to make sure you are covered and at a reasonable cost. Any change to your coverage should be made with careful consideration of your health, family needs and long-term financial plan.