How Life Insurance Works (Part 3)
Our previous installment of this article by David Roos from HowStuffWorks.com discussed who might need life insurance and what types of life insurance are available. In our third and final installment, we look at how much life insurance you might need and some tips on getting the right policy.
How much life insurance do I need?
Life insurance is just one part of a larger financial plan. How much life insurance you buy depends on the specific financial needs and circumstances of your family. The trick is to strike a balance between being over-insured and under-insured. Paying too much in premiums can be just as damaging to your overall financial plan as paying too little.
The easiest way to think about life insurance is as income replacement. The first step is to figure out exactly how much income you provide to your family. The next step is to figure out how long you're going to need to replace your income. As a general rule, you only need life insurance until your dependent children are out of the house or until your retirement savings kick in. The amount of coverage you need is also called the face value or death benefit of a life insurance policy.
But remember that the amount of life insurance you buy needs to fit within your budget. There's no point in buying a policy with a high face value if you can't afford the premium payments. If you can afford to pay a higher premium, though, you should think about purchasing a plan that will cover major life expenses, like covering the mortgage. Then there are other possible expenses, like taking care of aging parents, college expenses for children, or childcare costs if you're the primary caregiver.
If you start adding it all up, it may seem like a lot of money. But once again, you need to strike a balance. For most people, the idea of life insurance isn't to set up your family for life, but to help them get through the first 5 to 10 years after your tragic loss. That's why some experts fall back on the old life insurance rule of thumb: buy enough to replace your salary for five to seven years.
Life Insurance Shopping Tips
The first life insurance shopping tip is to buy when you're young and healthy. Young, healthy people pay much lower premiums, so look for a policy that has a fixed premium for the length of the policy.
A good insurance salesperson can help tailor a policy that's exactly right for your needs, but it certainly pays to be an educated consumer. Think hard before you buy a permanent life insurance policy. Insurance salespeople push whole life and other cash-value policies because they're big moneymakers for the insurance company and for the salesperson. The truth is that most people don't need permanent life insurance policies. They only need to replace their income until they've reached retirement age or their dependents are old enough to take care of themselves.
Insurance agents try to sell permanent life policies as investment vehicles and important cash reserves for low-interest loans. The problem with this argument is that there are many other tax-deferred investment instruments out there that have lower commissions and greater flexibility than permanent life insurance.
The idea of borrowing money from the cash value of your insurance policy also sounds attractive. But first consider your credit history and the likelihood of accruing more debt. If you have a good credit score, you can get low-interest loans from banks and other lenders. And if you default, you won't eat up your life insurance death benefit (the main reason you bought the policy in the first place).
At Gardner & Billing CPAs, we don’t sell insurance, but we can help you understand the tax implications of life insurance and how it fits into your financial goals. We can also help you look at how life insurance might fit into the larger picture of estate and succession planning.
