The prospect of our inevitable journey to the pearly gates is a tough conversation to have in any context, let alone attaching a dollar amount to our existence. However, for many people, life insurance is the backbone of any strong financial plan. Without it, all your other financial goals can easily fall apart. Life insurance can replace lost income, pay off debts, leave a charitable legacy, and create an income and estate tax-free pool of capital, if structured correctly. But how much life insurance do I need, if any? As with most questions, the answer depends on the facts and circumstances of your particular situation, as many quantitative and qualitative factors influence the final answer.
Income replacement is often the first consideration. It is important to ask yourself how much income your family will need to maintain their current lifestyle in the event of your untimely death. This will depend on a variety of factors, including your personal expenses, your spouse’s income level (as well as whether he or she will continue to work after you are gone), and the extent to which the success of your financial plan is predicated on your savings power. It is also important to realize that your family’s tax profile may change. For example, employment income is taxed at ordinary income rates and subject to payroll taxes. Life insurance proceeds, on the other hand, are often received income tax-free, and if reinvested could benefit from preferential capital gains tax treatment. It is also important to think about expenses that would increase. For example, if your plan is built on the assumption that one spouse will continue to work, you may need to account for childcare expenses.
The next discussion should relate to how your loved ones will manage the death benefit proceeds. Some people plan to use life insurance to pay off the mortgage and other debts and/or create a lump sum of money to pay for college and other major goals. Others focus solely on replacing income and leave it up to their heirs to make those decisions. If your plan is to pay off the mortgage, the cost of carrying the loan should be subtracted from the income replacement calculation to avoid double counting.
Consider the power of life insurance to create a potentially income and estate tax-free pool of capital if the policy is owned inside of an irrevocable life insurance trust (ILIT). For wealthier couples who otherwise may not have a need for life insurance, this may be a powerful tool to a) use the leverage of life insurance to leave a larger net inheritance to the next generation and b) create a liquid pool of capital at death. The latter is particularly important if you have an illiquid estate, since estate taxes are generally due 9 months after death. If your net worth is comprised principally of real estate or closely held business interests, it may be a challenge for your descendants to convert those assets to cash in a timely manner. In addition, if you are a partner in a closely held business, life insurance can be used in a buy-sell agreement that enables the surviving partners to pay off your heirs and retain control of the business.
A thorough life insurance needs analysis is not a simple A+B=C equation. It is important to speak with your advisor about your life insurance needs (and what type) to ensure that your family’s financial goals are taken care of no matter what life throws your way.
