Insurance is a huge business. I’m going to go through some of the most popular kinds of insurance out there and which one would benefit you the most…and which ones to avoid.
If you haven’t already, you will be approached by sales people cloaked as Financial Advisors who will try to sell you on why you should own various kinds of insurance. This is especially true once you start moving into a middle or upper middle class income bracket. Why? Because you’ll have more money to pay for insurance.
The TL;DR version: Get term life insurance that will cover at least 12x of your annual income or 25x your annual expenses minus your net asset base. Get this for a period until you reach an age when you won’t have any more dependents OR reach a point when you don’t need insurance. And yes, if you do things right, there will be a time you will no longer need life insurance.
Why does one need life insurance?
Life insurance is necessary when you have people who depend on you for their daily lives. This can include spouses, children or parents. Life insurance is also important if you’re a stay at home parent. Replacing a SAHP with a nanny, daycare or a combination of the two could be very costly. If you pass away, life insurance will pay out to your beneficiaries. Life insurance benefits are not taxed (if paid out to beneficiaries) and if the deceased had debts, life insurance can’t be touched by creditors if your beneficiary isn’t the estate.
Important note here: with life insurance you’ll want to make sure the beneficiaries are people or name your trust, or a trusted adult who will care for your children, not your estate. If your policy is part of your estate, or if the benefit goes into probate, creditors can go after these monies and depending on the amount of the estate, could become taxable. Its important that you keep your beneficiary info up-to-date. Also, bear in mind naming minor children can become problematic since many states won’t allow minors to claim a life insurance payout until they reach the “age of majority.”
A life insurance benefit will help your heirs make up for the financial loss of not having you. If you don’t have dependents you don’t have to worry about having life insurance.
How much life insurance do I need?
You’ll want to get enough insurance to cover at least 12x your gross income OR 25x your annual expenses minus your net assets. The idea is that we’re trying to make up for the income you used to bring in or expenses you used to cover.
For example, if you earn a gross of $80k a year, you’ll want ~$1,000,000 in insurance. The idea being that invested wisely, your heirs could earn in the neighborhood of 4% on that money to make up for your lost wages. Another way to look at this is if you have $40k in expenses every year. You’d want your loved ones to make enough off the invested money from insurance to cover these expenses so you’d need about $1mm in insurance. If you had $200k saved up, then you may only need $800k in insurance.
What kind of policy should I get?
A term life insurance policy. Don’t get fancy here.
How long do I need it for?
The good news is, if done right, in some point in the future you won’t need life insurance. How is that possible? It’s possible when you’ve created enough of a net worth that could work for your heirs to cover their expenses should you pass. If you build up a net worth of $1mm and it generates $40k in income annually which covers the expenses you used to cover, your dependents may have enough money without relying on life insurance.
You’ll want to be insured until you no longer have dependents on the income you generate while living. For many families, this point comes when their youngest child turns 21. For other families, it may be a shorter time horizon until they reach a certain asset base that generates enough passive income to cover their dependent’s expenses. This is an important reason why you don’t need whole life or a universal life policy. You don’t need insurance forever.
What should I avoid?
Avoid any insurance that’s pitched to you that would also act as an investment. The most likely insurance you may be pitched aside from term are whole and universal life insurance policies. These are expensive policies and they’re usually sold using very appealing marketing ploys:
- “These policies can be turned into cash and their values can grow!”
- “Not only are you insuring your life, you’re not going to throw all that money away on a term policy”
- “One fine day you’ll get all your money back and then some!”
- “Oh and by the way, these insurance policies are an excellent way to hide your assets and avoid taxes!”
A good rule of thumb is, the more complicated a product is the higher the chances the costs outweigh the benefits. Life insurance is where you want to keep it simple. In most situations, the promoted tax benefits from a universal or whole life policy will be more than eaten up by the amount in premiums you’ll pay for a whole or universal policy over a term policy. You are better off getting a term policy and investing the difference of what you would have been paying for a universal or whole policy.
If any agent tries to sell you an insurance policy on a child, run. Especially if they’re suggesting this policy could help pay for college one day. Open a 529 Plan instead. This post by the White Coat Investor does a great job laying out why you should never get a life insurance policy on a child.
The person who gets the best return on whole and universal policies is the insurance agent when they sell them. It’s highly unlikely that your whole life or universal life insurance policy will provide a better return than if you just invested that money in the stock market. Also, it’s not likely you’re going to have an untimely death. What’s more likely is that you’ll be paying hundreds of thousands of dollars for an insurance policy that is costing you more than it is benefiting you. The savings you might get by avoiding taxes are eaten up and then some by the premiums you’ll be forking over. Because of how expensive these policies are, you most likely won’t be able to reasonably afford one with a death benefit that would be 12x your current income.
Which company should I go with?
You certainly want to go with a reputable company that has been around for a long time. There are a lot of great local insurance agents out there who can get you a quote. If you’re like Mr. Moneyaire and would rather not talk to someone, try using a service like SelectQoute.com or PolicyGenius to shop multiple carriers at once.
When should I open a policy?
The sooner the better. Term policy premiums are cheaper the younger (and healthier) you start. Policies are also cheaper for women than for men. If any of these conditions apply to you (or have), you can expect your premium to be more expensive:
- Being overweight or obese
- Heart Disease
- High Cholesterol
- Sleep Apnea
- Alcohol or Drug Addiction/Abuse
- Depression and/or Anxiety
- Any other serious disease
What you can do to lower your premiums is to exercise, stop smoking, reduce your drinking, take medications on time, maintain a healthy weight, keep your cholesterol and blood pressure in check, and avoid dangerous activities. For policies with higher potential benefit payouts you can expect to have to undergo blood and physical tests so the insurer can gauge your health and thereby your premium amount.
Life insurance is a great tool to have, especially if you have dependents. Insurance is there to throw off risk in case something goes terribly wrong. Make sure you get enough insurance, keep your beneficiaries up to date, keep the investment out of insurance and only have the insurance for as long as you’ll have dependents. Life insurance can get complicated and expensive very quickly, but it need not be. Just keep it simple.