We all share the same inevitable fate. We do not know exactly when or how, just the final outcome. While life insurance will not delay your death, it will help leave behind a more secure financial future for your heirs.
At some point, usually their 20s or 30s, most people come to think that they should buy life insurance, either because someone suggests it or simply out of a vague sense that it’s a responsible thing to do. It’s easy to procrastinate or overlook life insurance - after all, you’ll never see any of its benefits, since you’ll be dead. But proper planning around life insurance can be a major benefit to your heirs, especially if you have sizable wealth at your demise.
As in all financial planning decisions, there is no one-size-fits-all answer to the question of when you should buy life insurance - or how long you should keep it. Life insurance is an essential for some, less important for others. And if you need life insurance, a variety of factors will inform how much and what kind of insurance is right for you. It’s important to consider, often and carefully, the factors that decide what amount of insurance is right for you, whatever your current life stage.
Why Do I Need Life Insurance?
In attempting to determine the need for life insurance - and, if so, what kind, how much and for how long - many people jump quickly to numerical calculations. It can be tempting to rush straight to one of the many insurance calculators available and start plugging in figures. However, it’s impossible to calculate your life insurance needs accurately without answering the first, more important question: Why do you need life insurance in the first place?
Life insurance is generally used for four main purposes.
- Personal Income Protection: This is the most traditional use of life insurance and the one that probably most concerns those first beginning to think about life insurance early in their careers. Life insurance used for income protection provides a way of replacing income in the event of your premature death. It is mainly used to protect and provide support for your dependents, whether young children or aging parents. Even if the income protection only extends far enough to cover your funeral and its related expenses, life insurance used this way is primarily meant to save your loved ones the burden of coping without your income for some period after your death.
- Business and Partnership Income Protection: While this use is less common, life insurance can serve the same income protection function for a business as it can for a family. In this case, the business itself is generally the owner and beneficiary of the policy. What would happen to a small business if a key employee died unexpectedly? The financial benefit of a life insurance payout could help the business substantially during what will always be a difficult transition.
- Estate Tax Liquidity: Life insurance can serve a specialized purpose for individuals who own non-liquid assets, such as businesses or real estate, and who expect to be subject to estate tax. Since estate taxes must be paid with cash, heirs are sometimes forced to sell all or a portion of the estate’s illiquid assets at a discount to their market value in order to have the necessary cash at hand. A life insurance policy in the appropriate amount can be used to provide the estate with cash to cover the tax bill and allow the heirs to preserve the illiquid assets or to sell them at a more profitable time.
- Wealth Transfer: Life insurance can also be an effective means to transfer wealth to younger generations without incurring an unwanted tax burden. When life insurance policies are set up properly for this purpose, proceeds are generally free of both income and estate tax, maximizing the value passed to the next generation. Besides avoiding tax, you can also use a life insurance policy to transfer funds outside of probate, since funds pass to a beneficiary directly.
After you determine the purpose your life insurance would serve, the questions of whether you need it, how much you will need, and how long you will need it all become far easier to answer. If the insurance is mainly for income protection, whether for your family or your business, you will only need insurance for as long as your family or business is reliant on your income, and you will need enough to take the place of that income until it would stop being necessary.
Insurance for estate tax liquidity or wealth transfer purposes, on the other hand, continues to be necessary for as long as you have illiquid assets to pass on and not enough cash to pay any expected estate tax liability. For estate tax liquidity purposes, the amount of life insurance you need can usually be calculated based on the expected tax on your estate. For wealth transfer purposes, the decision of how much to transfer through an insurance policy needs to be part of your overall investment and estate plan.
| Life Insurance Purpose | ||||
|---|---|---|---|---|
| Personal Income Protection | Business Income Protection | Estate Tax Liquidity | Wealth Transfer | |
| Do you need insurance? | Do you have dependents who would suffer from the loss of your income? | Would your business suffer from the loss of the income/sales you generate? | Might your heirs need to liquidate businesses or property to pay estate taxes? | Does a life insurance policy fit into your overall investment/estate plan? Do you want/need to guarantee a certain amount for your heirs? |
| How much do you need? | Enough to replace your income for as long as your dependents would be reliant on it | Enough to replace your earning power for as long as the business would be reliant on it | Enough to pay the estate tax that would be due on the businesses or property you are leaving to your heirs | As much as fits with your overall investment/estate plan or as much as you want/need to guarantee for your heirs |
| For how long do you need it? | As long as your dependents are reliant on your income | As long as the business is reliant on the income/sales you generate | As long as you have business interests or property to transfer to your heirs and expect that your estate will be subject to tax | As long as you continue to have assets you want to transfer to your heirs and as long as an insurance policy continues to be the best means of doing that |
When Do I Need Life Insurance?
As the chart above suggests, the duration of your life insurance will be dictated, to some degree, by its use. That, however, does not address the question of when to purchase life insurance in the first place.
As with other decisions about life insurance, the insurance’s purpose is a good starting point. If you are considering insurance primarily as a means of income replacement, you are unlikely to need much, if any, if you have no dependents and are not a business owner. You might consider a policy to cover final expenses or any outstanding debts, such as mortgages or student loans, in order to avoid leaving those burdens to your survivors; however, you are unlikely to need the longer-term income stream a parent of young children might want to secure.
Similarly, a person nearing or at retirement age, whose children are independent, may not feel the need to preserve an income stream any longer. On the other hand, if that person’s spouse relies on his or her pension, the need to protect income may remain.
Besides age, there are other life changes that can shape your need for life insurance. You should revisit your life insurance needs regularly, but especially re-evaluate if you get married or divorced, have a child, buy a home, or approach retirement.
Young people in relatively good health also have an opportunity to make the most of relatively low rates by either combining types of insurance or by buying a policy that can convert from one type to the other. This is because insurers may not require a new medical exam when you convert your policy or shift money from one policy to another, allowing your original physical to secure you a better rate. However, most policies can only be converted until the insured reaches a certain age, so be aware of the restrictions when choosing a policy. Also beware of policies that offer attractive premium rates but require you to submit to periodic physicals, usually at intervals between five and 10 years, to avoid dramatic rate increases. Such “re-entry” provisions shift the risk of future declines in your health from the insurance company back to you, which is what we usually seek to avoid when we buy insurance in the first place.
What Kind of Insurance Do I Need and How Much?
Once again, the purpose of your life insurance will largely shape your choice of what kind of insurance to purchase. While you can choose among a wide variety of policies with an assortment of provisions and riders, life insurance can be divided into two main categories: term insurance and whole life insurance.
Term insurance provides coverage for only a certain time period (or “term”). A term insurance policy can have a term of just one year, in which case it is called an annual renewal policy, or a term lasting a longer period, generally ranging from five to 30 years, which is called a level term policy. Premiums remain the same throughout the term. While term insurance policies can usually be renewed for additional terms, premiums increase with each renewal, as the insured gets older and the likelihood of death rises. Some term policies may not be able to be renewed at all after a certain age, typically between 70 and 80.
Unlike term insurance, whole life insurance - sometimes called permanent insurance - is designed to last until it pays out. However, because every policy can eventually be redeemed, whole life insurance cannot run on the same simple, pure insurance model as term insurance. Instead, whole life insurance policies are typically built around the accumulation of a cash value, which is used to fund death benefits when they are eventually paid. Whole life insurance is often described as a combination of a term policy and a tax-sheltered savings or investment account.
Because premiums rise rapidly with advanced age, term insurance works best if you are concerned only with a particular time span with a foreseeable end point. In most cases, this will be the time when your dependents stop being reliant on your income. Since whole life insurance is guaranteed (so long as premiums are paid) and accumulates cash value, it works well as a means of providing money to heirs after death. This can be either just enough to cover estate taxes or a sum that you intend to pass to your heirs. Because of the investment component, however, whole life insurance is generally more expensive than term insurance early in life, and therefore is a poor choice for those who want to protect against loss of income for only a set time.
Whether you select term or whole life insurance, how much you need will be determined largely by the first question you considered - the purpose of the insurance. While it’s tempting to just buy the amount of permanent insurance that fits your budget and be done, this is seldom optimal. Instead, consider what present obligations or desires the insurance would meet, and what is likely to change about them in the future. A qualified financial adviser can help you estimate your needs and navigate the information you get from insurance agents as you research policies. Once you have a good idea of how much you’ll ultimately require in order to meet your goals, you should compare policies’ premiums, as well as the financial strength of the companies offering them.
Your insurance needs will change over the course of your lifetime, and it’s never too early - or too late - to consider how much life insurance makes sense for you. Don’t fear death; plan for it.
