Life Insurance – Protecting Your Ass(ets) Part Deux

Life insurance. Its a product everyone ends up paying for it, but no one actually wants to collect on it! Questions that commonly arise are what type of insurance should I get and how much. That’s what we will explore here.

How much do I need?

How much insurance should you have? Like so much else in life: it depends. When you are first starting out, perhaps you don’t have dependents to worry about. Unless you parents co-signed on private loans, you probably don’t need insurance. If they did, you need to be responsible and have enough insurance to cover them. If something were to happen to you, they would still be responsible for the money. (Note: this likely doesn’t apply to Parent+ loans which are still federal). If you live in a community property state (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin) your spouse could be liable for student loans you acquire after marriage. So read the fine print and plan accordingly.

At some point, most of us suddenly find ourselves with “dependents.”  You know, the little ones that allow us an extra deduction on our taxes. The question to ask yourself is – if I disappeared tomorrow, how much would it cost to get them through ___________ and pick a goal. It’s a question only you can answer. For me, the goal was to be certain that my children could continue to go to their K-12 primary school and then college. So I needed enough insurance to make up up to 22 years of income. Things to consider are your income’s contribution to food, shelter, tuition, etc. For most of us it’s our out after tax, after 401k income. (Monies received from a life insurance policy are not taxable.) The other factor to consider is your significant other. If you are the primary income earner, how will you provide for them? If you are both income earners, what would happen if something happened to the two of you. Unpleasant thoughts, but they are essential.

Term-life insurance, whole life and universal life

When we talk about life insurance we generally are talking about term-life insurance, whole life and universal life. Term life insurance is the simplest to explain.  Essentially when you get a term life insurance policy, you agree to pay a fixed monthly amount for a specific period of time – after which the insurance policy expires. If you die during the period in which the life insurance policy is in-force, you collect a fixed amount. It’s the least expensive of the insurance policies. For most of us, it’s the only policy that makes sense. One potential strategy is to buy more than one policies with staggered terms. Let me give an example. You make $100k a year. If you have newborn twins you and you want to be able to replace your income through their college education. If you were die tomorrow you would need about $1.4 million in life insurance ($70,000 after tax money * 22 years). But if you live to see them start high school – and you most probably will – then you would need only about $560,000 in insurance. And if you make it to freshman year of college – and you most probably will – then you will need only about $280,000. So when they are born, you can take out 2 staggered policies one for ten years and one for 20. This way you only pay for as much insurance as you need.  Term life insurance policies are inexpensive and readily available from independent agents. A 30 year old can buy a $1.0 million policy for as little as $350/year. Be sure to get multiple quotes.

We will talk about whole life and universal life as a single product even though there are differences. Essentially these are permanent insurance plans protect you for life. No matter when you die – age 40, 70 or 90 – you get a specified payout. There is no term.  These are expensive policies that are really a hybrid insurance policy / investment vehicle. I don’t recommend them. Ever. Every month that payments are made, a portion of the premium is applied to the cost of the life insurance and another portion of the premium is invested. The idea is that the investment portion will grow over time and eventually may even be able to pay for the premiums of the life insurance.  Agents will expound on the virtues of such a policy: You can borrow money from the investment portion of the policy (yea, and pay interest), You can withdraw money from the investment portion (yea, and reduce the death benefit).

Why no one needs whole life or universal life insurance!

Insurance companies love these policies because no matter how much money you leave behind in the investment portion, when you die your heirs receives only the benefit specified in the policy. The insurance company essentially uses the investment portion to pay the claim. And if you borrowed or withdrew money, it reduces the benefit! Agents love these policies because they can make 50%-80% of the first year premium as a commission! But why do I really hate these policies? Because there has never been a time when an individual who had one of these permanent policies financially outperformed an individual who purchased a term policy and invested the difference in the cost of the term and permanent policies in an indexed mutual fund. And, the individual with the term policy, the funds invested in the mutual fund really is theirs to keep!

Ask yourself, why do I need a policy that pays out when you are 70? Your spouse will get your assets so he/she is in the same financial position as when you were alive. Unless you are planning to endow a chair at your alma mata, why would you need permanent insurance. Don’t mix insurance with investing. No matter what glossy projections the agent slides in front of you – ignore it. Take a term policy and then invest the difference between the cost of the term policy and a permanent policy.