Creating
a Life Insurance Action Plan
Life insurance is a key
element of any financial plan – not because it protects your life but because
it provides financial protection for your family. Life insurance is the safety
net that ensures a family will have the assets it needs if the insured person
were to die prematurely. Exactly how much you need can vary during your
lifetime. That’s why it’s important to periodically conduct a life insurance
assessment. Here’s what to do.
Action Step 1 – Examine Your Current Family
Situation
The key to determining whether
you need life insurance is your family’s financial vulnerability – or their
ability to financially provide for themselves when you’re gone. Keep in mind
that the purpose of your life insurance is twofold. The proceeds of your policy
will serve to (1) pay off immediate expenses such as cost associated with any
final illness, funeral expenses, and estate taxes and (2) provide for your
family’s ongoing financial needs.
If you are a working parent
with young children, you can be fairly certain you need life insurance. Once
your children finish college and are out on their own, you may be able to reduce
the amount of life insurance you carry, depending on the financial independence
of your children. When you retire, there may be no need for life insurance if
you have sufficient resources to support yourself and your spouse in retirement.
However, carrying life
insurance with your spouse as the beneficiary will help to ensure that he or she
can maintain the same lifestyle after you’re gone and provide both of you with
added financial peace of mind.
Action Step 2 – Calculate How Much Insurance You
Need
Once you have determined that
there is definitely a need to provide life insurance, the next step is to
estimate the proper amount of insurance for you.
The simplest method is to
calculate your life insurance need as a multiple of your annual earnings.
Experts suggest various multiples — anywhere from five to ten times your
annual earnings. While this method is easy, it does not take into account a
family’s personal goals and unique financial circumstances.
The preferred method for
determining an appropriate amount of life insurance is based on evaluating your
current financial position and estimating your expected financial needs.
Consider your family’s annual income requirements, as well as the need for
emergency funds, debt repayment, college funding, and survivor retirement
income. Next, tally your income sources including the surviving spouse’s
income, investment income, Social Security funds, death benefits provided by
your employer, and retirement plan assets. By comparing your family’s
anticipated expenses with your expected income, you can determine the gap and
what needs to be funded with life insurance.
Action Step 3 – Determine the Right Type of
Insurance
Life insurance comes in two
basic forms -- term insurance and whole life insurance. Whole life insurance, or
cash value insurance, as it is sometimes called, combines a death benefit with
an investment element. The annual premium is higher than what is needed to cover
the risk of your death in the early years of the policy. The excess amount funds
a cash value that grows over the life of the policy. Policyholders can access
the policy’s cash value by taking out a loan against the policy or by
surrendering the policy.
Term insurance, on the other
hand, provides plain protection for a specific period of time. Since term
insurance provides the largest amount of coverage for your premium dollar, it is
usually the best way to replace lost income. The premiums on “annual renewable
term” insurance increase each year. In contrast, a “level term” policy
charges a premium that is initially higher than the rate for annual renewable
term, but your premium remains fixed for a period of 5, 10, 15, or 20 years. On
the down side, term insurance offers no cash value, regardless of how long you
hold onto the policy.
In constructing your insurance
plans you should keep in mind that life insurance proceeds are free of income
tax. This does not mean, however, that life insurance proceeds will
automatically be free of estate tax. In order to prevent estate tax, you may
have to use an insurance trust.
For more details on how to set up an insurance
trust, see your tax professional.