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How Much Life Insurance Do You Need?

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It has been said that life insurance is like a parachute. If you don’t have it when you need it, you will never need it again. But how much life insurance do you really need?

There are really only two reasons to purchase a life insurance policy: 1) to pay off a debt or obligation, and 2) to replace an income or cash flow. If you don’t have either of these needs, then you do not need life insurance.

While some insurance agents propose a third reason is to use the tax-deferred build-up of cash value within a life insurance policy to supplement saving for retirement or a child’s college education, I would not recommend that unless you also have the basic need for the underlying death benefit; the cost of the policy is too much of a drag on the investment return. In other words, using life insurance as purely an investment vehicle with no need for the death benefit is, in my opinion as a Certified Financial Planner, ill-advised.

Pay Off a Debt or Obligation

Most people do not consider purchasing life insurance until they have a family. However, even single individuals might consider owning a policy to retire a debt or obligation like a mortgage, car loan, consumer loan, or a tax obligation.

If you have no heirs, then (depending on state laws) your outstanding obligations will generally be offset by any assets you own and the remaining balance will have to be written off by the lender. If, however, you would like your assets to go to an heir, you should consider purchasing enough insurance to pay off any debts upon death.

Of course, if you have a family dependent upon you, then it certainly makes sense to have an insurance policy in an amount to at least satisfy any outstanding debts. Life insurance proceeds are nearly always income tax-free, so there is no need to calculate the effect of taxation on the death benefit when calculating the amount needed to pay off a liability.

Most debts or obligations are readily apparent, but some tax bills do not materialize until death and are not necessarily so obvious. Income taxes must be paid by the beneficiaries upon the participant’s death for tax-deductible IRA and 401k plans. (Non-deductible Roth plan balances are generally income tax-free.) While these tax payments may be stretched over the beneficiary’s life expectancy, you still may want to provide for those obligations with the proceeds of a tax-free insurance policy.

The maximum federal estate tax is 40% and is due in cash within 9 months of death. If your estate is less than $5,450,000 or $10,900,000 for a married couple (2016 values, indexed), then you will escape this punitive tax. However, 18 states have their own inheritance or estate tax that may be due upon death. State tax obligations can reach as high as 20%. It may make sense to purchase a life insurance policy to pay any of these tax obligations.

Replace Income or Cash Flow

The second reason to own life insurance is to replace an income or cash flow. If your family depends upon your income for necessities, then the loss of that income from your death can be addressed by life insurance. Other cash flows that might cease upon death include child support, alimony, and pension payments. Sometimes a divorce decree will mandate that an insurance policy is in place for a specified period of time. Regardless of the type of cash flow or income you are replacing, the calculation is the same. Essentially, you would want to provide a lump sum payment to generate an after-tax income equal to the annual cash flow lost.

Here are two steps to calculate the life insurance you might need.

1. Calculate the Net Rate of Return

The lump sum will need to be invested in an investment portfolio. The rate of return assumed should be the expected long-term return for the underlying investments. Assuming a moderate risk income portfolio could earn a gross return of 5% per year, you need to adjust for taxes and inflation. (This rate of return does not represent any actual investment and cannot be guaranteed. Any investment involves potential loss of principle.)

While the insurance death benefit is tax-free, the income generated from it is not. If you assume an income tax rate of 15%, then your net rate of return would be 4.25% (5% X (1.0 -.15)) If inflation is expected to be 2% per year, then the 4.25% portfolio will only really earn approximately 2.25% (4.25%-2.0%). To be clear, the account would earn 4.25% after tax, but if you want the income generated to keep up with inflation, then you have to reduce that after-tax rate by the inflation rate when calculating your insurance need.

2. Calculate the Lump Sum Needed

Now that you know your net rate of return is 2.25%, you would need to calculate the lump sum necessary to replace the income lost by the deceased earner. Simply divide the amount needed by the inflation-adjusted, after-tax rate of return. Assuming you need to generate $50,000 a year, the account must have about $2.2 million in it to generate the necessary cash ($50,000 divided by .0225). So, in this instance, you should purchase a $2.2 million life insurance policy.

Of course, if you already have other assets like a retirement plan or group life insurance, you can reduce this need by the amount of those resources. While $2.2 million may sound like an exorbitant amount of insurance, keep in mind that you are replacing a lifetime of earnings. If the above assumptions hold, then your family will receive $50,000 after-tax per year, increasing by 2% per year for the rest of their lives.

If you need to retire a debt and replace your income then add the result of the two steps together to determine the total life insurance need.

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