Life happens and so does death.Â Although most of us would prefer not to dwell on the second part of that equation, preparing for an untimely death and protecting those who depend on your livelihood is one of the most important financial decisions you can make.
Take for example Shronda Smith, a self-employed hair stylist living in the south suburbs of Chicago, and her husband, Fred Smith, owner of The Lord’s Hands Barbershop in Calumet City, Illinois. Before they exchanged vows in December 2009, they were collectively insured for $450,000. Once they were married, however, the couple, both 38, realized that if one of them were to die then their blended family–consisting of two children, Emani, 15, and Fred Jr., 13–would be left financially vulnerable.
ShirleyAnn Robertson, a Chicago-based Prudential Financial Inc. agent with 18 years of experience, suggested that the Smiths purchase enough life insurance to bury the deceased spouse –an expense of roughly $10,000–and replace his or her portion of household income for mortgage payments and other monthly expenses until the children turn 21, a cost of approximately $50,000 to $60,000 per year for eight years. (The Smiths’ collective annual income is about $110,000.)Â Moreover, the coverage should also help finance both kids’ college education, a total cost of $56,000 a year based on The College Board’s report of an average annual undergraduate’s tuition and fees at a public four-year school. That would mean the Smiths need a minimum of $1 million of coverage each.
Robertson suggested an inexpensive way to meet their needs. The Smiths now have a combination of term and whole-life policies. They pay a premium of $365 per month.
Buying life insurance can be as easy as going online and logging on to one of many different websites such as Insure.com and Accuquote.com. But choosing the right insurance based on your personal circumstances takes more thought. “The reality is, life insurance is loving your family enough to plan for the unexpected. It is a legacy of love for your family, allowing your loved ones to carry on with their lives,â€ says Robertson. “A lot of people become so fearful of making the wrong decision or think that it’s morbid to anticipate the worst, they fail to plan.â€
Nearly a third of American adults, in fact, are uninsured, according to LIMRA International, a Windsor, Connecticut-based insurance industry association. And 40% of adults who are insured believe they don’t have enough coverage. Many adults are likely to carry only the group life insurance they receive through an employer, LIMRA reports.
Choosing the best type of insurance requires you to determine how much you can afford to pay over a long period of time, says Robertson. Next, identify specific financial goals for you and your dependents. “Everyone’s financial scenario is different,â€ says Robertson. “There’s no cookie-cutter solution, therefore, it’s important to complete a ‘financial needs’ analysis to create a financial road map.â€ Keep in mind, dependents might include people other than spouses and minor children. For example, your death could affect a retired or ailing parent who is dependent on you for supplemental income or a small business you operate.
Opinions on the purpose of life insurance vary. Some experts believe it should be purchased purely for the death benefit or monetary disbursement released upon the death of the policyholder. The value of the death benefit, they maintain, is to pay debts, taxes, and interment expenses, and replace lost income for dependents until they’re able to provide for themselves. Others believe in using such policies as a savings vehicle.
Term Life Insurance
Term life insurance, which covers you for a specific number of years, or aâ€term,â€ fulfills the need for basic coverage. For a low monthly payment, which can range from $300 to $600 per year (premiums vary depending upon one’s age and health) a 40-year-old individual can subsidize his dependents with a $500,000 benefit upon death, based on Accuquote.com. The advantage of term insurance: It’s inexpensive, and ideal for younger families and individuals on a budget. In fact, individuals can purchase the same death benefit for even less through an employer’s group term insurance plan.
The disadvantage is that after your term expires, you don’t have any insurance,says Ivory Johnson, director of financial planning at Annapolis, Maryland-based Scarborough Capital Management Inc. “At that point to go back into the market to get insurance can become very costly because you are much older.â€ As age increases and health deteriorates, premiums for new policies increase. If you buy insurance early you may have the option of locking into a low rate with a guaranteed policy that renews at the same premium at the end of the term regardless of your health.
Whole-life insuranceÂ differs from term life insurance in that it doesn’t expire and that it has a cash value feature that allows policyholders to save money in addition to receiving a death benefit. But it requires much higher monthly premiums. What’s the upside for this type of policy? The cash value portion is saved tax deferred and can be invested in stocks, bonds, and mutual funds, depending on the product.
The policyholder can borrow from the cash value or against the death benefit before retirement age and that money can be applied toward just about anything, including the purchase of a home, children’s college tuition, or retirement. But you will be charged interest on the loan until it is repaid. This type of insurance is helpful for older people who would end up paying more money anyway if they tried to get a term policy after they’ve suffered from health problems. Another advantage: it’s permanent and not limited to a “term.â€
The downside? Cash value insurance can be five to eight times more expensive than term and doesn’t make sense for younger consumers who are single and don’t need a larger death benefit when they don’t have dependents, says Johnson. Young adults, he says, can still save tax deferred through retirement products such as a 401(k) that allocates less to administrative costs. “I don’t think [cash value insurance] makes sense for younger people because the money that they would put into a permanent life insurance policy they could allocate to less expensive ways of managing the money,â€ says Johnson, a financial planner with 20 years of experience. “If you need life insurance, get life insurance; if you want to save money, save money.â€
Also, insurance shoppers should not invest in cash value insurance if they are unable to afford the monthly premium, because they could end up losing not only the insurance, but the money they’ve invested. Yet, Robertson sees the advantages of both types of products. “In each age group a cash value [can be] good and in each age group a term policy [can be] good. It goes back to what are the client’s objectives. At the end of the day you’ve got to provide for your family.â€
Calculate How Much Life Insurance Coverage You Need
- Estimate the number of years before your youngest dependent will no longer need financial support. If your spouse does not work, you might also want your policy to cover your spouse until they are eligible to collect Social Security at age 65.
- Multiply your annual salary (before taxes) by the above number.
- Add your funeral expenses.
- If you own a business, add the cost to find and hire an employee to replace your position. (Consider arranging a “buy — sellâ€ agreement, a legal document backed by insurance, which provides the funding needed for partners or stockholders to take over the business or buy back shares you willed to your beneficiaries.)
- Add your financial obligations, including mortgage, debt, estate taxes, and taxes for the year of death. (Also, consider adding the cost of the monthly premiums for your spouse’s life insurance, to protect the children in case both parents die.)
- Add anticipated financial needs for the future, such as college funding for each dependent and extracurricular activities such as class trips, piano lessons, karate classes, etc.
- Add the financial value of services, such as lawn/house maintenance, tax preparation, childcare, you provide for the household, which will need to be replaced by a professional upon your death.
- Add 3% each year for inflation.
- Subtract your spouse’s salary multiplied by the number of years they plan to work after your death.
- Subtract money in your retirement, savings, and pension accounts, and the benefit your family would receive from other insurance policies.
- Subtract the money your beneficiaries will receive from the Social Security Administration on your behalf. (Go to www.ssa.gov/planners/calculators.htm to calculate those death benefits.)
- Finally, subtract 6% for potential yields from investments.