Navigating the Life Insurance Maze:  Unbiased Information to Help You Choose the Right Policy

If you’re a parent, chances are that you’ve received more than a few phone calls from insurance agents looking to sell you a large life insurance policy. Often, the policy they’re selling (and hard!) is a whole life or universal life policy that costs thousands or tens of thousands of dollars per year. “You need it to protect your family,” they say, “and it has incredible tax benefits!” They may send you information on the policy – with reams of incomprehensible numbers.

With a family to support, you know you need life insurance; however, the terms and conditions and numbers are so overwhelming, you’re not even sure what you would be buying.

So how do you know what you actually need, and where can you turn for unbiased answers? This article provides some basic information to help you get started. You can also get advice from certain fee-only financial planners who don’t receive a commission on financial products. There are also a few advisors who specialize solely in life insurance and charge clients at an hourly rate.

Below are our unbiased answers to some common life insurance questions.

How much insurance do I need?

Several factors affect how much insurance you should have, and each family’s analysis will be slightly different. The best way to determine the amount of insurance you should purchase is to figure out how much money your family would need to live comfortably if something happened to you.

A good starting place is your current income, which usually reflects your financial contribution to the household and your family’s standard of living. If you expect your income to increase substantially in the near future, your current income may not accurately reflect your true earning power or the standard of living you envision for your family. For example, if you are in graduate school, starting a business, or completing a medical residency, your income may currently be much lower than you expect it to be in a few years. If this is the case, it may be better to look at the amount of income you expect to earn in the coming years or the amount of income you think would be sufficient to provide a comfortable lifestyle for your family. We’ll call this amount your replacement income.

Next, from your replacement income, determine the amount that you expect to allocate to support your family over time, which we’ll refer to as your family financial contribution. This shouldn’t include any amount spent on yourself individually. If you won’t be around to make the money, you won’t be around to spend it either. It should, however, include the support you to intend to provide to your spouse, especially if he or she is the primary caregiver. If you earn far more than is necessary to maintain your family’s quality of life, the excess can be excluded.

Next, consider the value of non-financial contributions you make to the household, especially if you are the primary caregiver. For example, watching your children, taking them to doctors’ appointments, managing school and extracurricular activities, and tutoring are all activities that fall into the category of non-financial contributions. While you don’t get a paycheck for doing these things, your spouse might have to pay someone to do them if you weren’t around. If you are the primary caregiver, look at the cost of hiring a full-time nanny in your area. Your life insurance should reflect that financial cost.

Finally, consider any financial goals for your family that you intend to fund, for example, your children’s education, part of your spouse’s retirement, a family vacation home.

Adding your family financial contribution, the to the value of your non-financial contribution, and your expected contribution to other financial goals for your family provides a rough estimate of the total amount that would be necessary for your family to maintain their standard of living if you passed away. The primary role of life insurance is to ameliorate or compensate your family for that loss.

It is important to consider how the financial needs of your family are likely to fluctuate over time. If you have a young child who goes to private school, you can expect those costs to continue until the child graduates from high school. If you plan to pay for the child’s college or graduate school, then you should expect substantial costs during that period. Your non-financial contribution is likely to decline as your children get older and need less direct supervision. Once your child completes his or her education and (hopefully!) becomes a self-sustaining adult, your family’s household costs should decrease substantially.

Example

The example below illustrates how these calculations play out.

John and Jenny have two children, ages 4 and 6, and live in New York City. Jenny and John each earn $250,000 per year. They send both of their children to private school, which costs $30,000 per year per student, and have a mortgage payment of $7,000 per month.

The couple’s annual take-home pay after taxes is $300,000. Their household expenses are $140,000 per year, which includes an annual contribution to a college fund for the kids, and they each put away $50,000 for retirement. They have individual expenses (clothing, transportation, health insurance, etc.) of approximately $30,000 each. Jenny and John each provide non-financial contributions to the family (e.g., coordinating the children’s schedules, arranging extracurricular activities, watching the children, and tutoring) valued at $20,000.

Adjusting for inflation, John and Jenny expect their expenses and income to remain relatively constant for the next 20 years, at which point, their mortgage should be paid off and their children will have graduated from college. They expect their annual household expenses will then drop to $100,000 (in today’s dollars). Jenny and John expect to retire in 40 years, at which time enough money should be saved to provide for a comfortable retirement. Their retirement expenses are likely to drop by 40% if one of them passes away before then.

In order to determine how much how much life insurance they should purchase, they should break their calculations down into two time periods: Years 1-20 (their childrearing years) and Years 21+. They should also look at any large financial goals they have for their family.

Years 1-20

Jenny and John’s contributions to the family are most critical in Years 1-20, when their children are young and their expenses are at their highest. In these years, each spouse’s total contribution to the family equals $90,000 per year: $70,000 in household expenses plus $20,000 in non-financial contributions. This amount includes enough yearly savings to pay for the children’s college education.

Years 20+

Because both spouses work and are able to support themselves, the loss of one income will not devastate the other spouse after the children are grown. If, however, John or Jenny stayed home with the children and sacrificed their career, the loss of one income would seriously affect the other spouse, not just during their childrearing years, but into retirement, when the caregiver spouse would expect to share in the retirement savings of the primary breadwinner. In this case, the primary breadwinner should have more insurance to ensure the other spouse would be taken care of.

Family Financial Goals

In addition to replacement of their annual household contributions, John and Jenny might want their life insurance to replace their intended contributions to other financial goals of the family. Jenny and John intend to buy a vacation house for the family around the time the children graduate from college in Year 25. They may wish their family to have the resources to make the purchase even if they had passed away. We’ll assume the cost of the vacation home is $200,000, and John and Jenny expect to contribute equally to the purchase price.

Because the cost of their children’s college education is factored into the family’s annual household expenses, the cost of their children’s higher education does not need to be included as a separate goal. If this weren’t the case, however, then they might wish to factor it into their insurance coverage by including it as a separate financial goal.

To calculate the amount the family would need if either of them died in Year One, we would calculate the present value of amount that would be necessary to provide $90,000 in Years 1-20 (to cover household expenses and non-financial contributions to the family) and $100,000 in Year 25 (to pay for the vacation house). The present value incorporates the rate of inflation affecting the family’s expenses and the likely rate of return from investing a lump sum death benefit in Year One.

Jenny and John will each want a policy that provides a death benefit sufficient to provide their family with $90,000 per year (in today’s dollars) over the next 20 years plus $100,000 (in today’s dollars) in year 25. Adjusting for 3% inflation and applying a 5% rate of return, we get approximately $1.6 million. John and Jenny should each have a life insurance policy worth at least $1.6 million to achieve their goals. They may wish to increase that amount to provide a cushion for extra expenses or unexpected events.

What are the differences between whole, universal, and term life insurance?

Navigating the different types of life insurance can be challenging.  While there are an overwhelming number of policies out there, whole life, universal life, and term life insurance are the three main categories.

Term insurance is the simplest and least expensive type of life insurance. A term policy provides coverage for a certain “term” of years for a set annual premium. When that term is up, the premium often increases significantly to account for your age. For example, a 40-year old man might pay $650 per year for a 20-year term policy with a death benefit of $1 million. At the end of the 20 years, he might be able to renew it for $5,000 per year. If he has developed a health condition, the premiums may be much higher, or he may not be able to renew the policy at all. For an additional cost, some term policies allow the owner of the policy to automatically qualify for another policy when the term expires, regardless of the insured’s health.

In comparison to a term policy, whole life premiums are far more expensive. A $1 million whole life policy for a 40-year old male might cost $6,000 per year – significantly more than a term policy. However, the premiums never increase, and he can maintain the insurance regardless of his health.

Whole life insurance is best thought of as a term policy plus an investment vehicle. When you are younger, the insurance company allocates a portion of the premium to term insurance and invests the remainder to build up a cash value and to offset the higher cost of insuring you as you get older.

In most cases, purchasing a term policy and investing the remainder in a solid, diversified portfolio will provide a higher return than purchasing a whole life policy and having the insurance company invest the money for you. Separating your investment from your insurance allows far greater flexibility to respond to changing plans or circumstances. If you decide to use the investment portion to, say, buy a vacation house instead of saving it for your heirs until you pass away, there is no penalty if you have simply invested the money in stocks and bonds. If you had invested the money in a whole life policy and wanted to use the funds from the policy, you will pay a heavy financial penalty from cancelling the policy and withdrawing the funds.

A universal life insurance policy is a hybrid between a term policy and a whole life policy. A universal life policy allows greater flexibility in the investment portion of the insurance, with the potential to earn higher returns and reduce premiums in later years. However, like a whole life policy, it cannot easily be cancelled, and if the investment portion fails to perform as expected, premiums can skyrocket in later years.

A whole life policy may be a good choice if you intend to hold the insurance policy your entire life – not just for a period of time. Although you can surrender the policy at any point, you can incur a steep penalty for doing so. Therefore, if you expect to need the money at some point in the future, for example, for your retirement, you are probably better off getting a term policy and allocating the difference in premiums to another type of investment vehicle with more liquidity.

What are the tax advantages of life insurance?

Life insurance has two income tax benefits. First, any increase in the value of a life insurance policy is generally not subject to income tax. Second, the proceeds of a policy are distributed tax-free to the beneficiary.

Although life insurance proceeds are not subject to income tax, they are subject to estate taxes. For many parents with young children, their life insurance pushes them above the federal estate tax exemption of $5.43 million. If you believe your insurance policy might subject your family to estate taxes, you can often eliminate your estate tax exposure by transferring the policy into an irrevocable life insurance trust.

Life insurance agents often promote the tax benefits of large whole life or universal life policies; however, tax benefits alone do not make life insurance a good investment. It is important to look at the potential tax savings in light of the overall financial benefits. This may vary depending on your financial circumstances.

What Kind of Policy Is Best for My Family?

In most cases, a term life insurance policy is the optimal choice for parents with young children. This is the only type of policy that allows you to separate the insurance function of a policy from the investment function, and its lower premiums free up money to save for your retirement – or any other financial goals. Even with its tax benefits, the return on a life insurance policy will rarely equal returns from an individual investment portfolio, and you may pay heavy penalties if you need to withdraw the money.

There may be some cases where purchasing a whole life or universal life policy makes sense. In most states, including New York, the cash value of a life insurance policy is exempt from bankruptcy, and therefore unreachable by creditors. If you are a doctor or otherwise have a high risk of being sued, putting money into a life insurance policy can make a lot of sense.

Because of the complexity of various life insurance policies, most parents would benefit from professional advice – ideally, from someone other than an insurance agent – prior to purchasing a policy.

About the Author

Shannon McNulty

Shannon McNulty is the founder of Savvy-Parents.com and a lawyer in New York City who provides legal planning for parents with young children. Shannon received her J.D. from Georgetown University Law Center and her LL.M. in Taxation from NYU School of Law. She has also earned her CERTIFIED FINANCIAL PLANNER(TM) designation. You can learn more about Shannon and her firm at www.cityparentslaw.com.

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