Do you ever wonder if you have enough life insurance or if you’re properly covered? If so, you’re not alone. One of the most common questions we are asked by our clients is whether or not they have adequate life insurance coverage.
In this article, we’re going to help you answer this question, and provide some guidance on how to calculate how much life insurance you need.
WHY YOU SHOULD HAVE LIFE INSURANCE
If you’ve never purchased a life insurance policy before, you might be wondering why you should even consider buying life insurance in the first place.
Interestingly, most of us have already purchased several types of insurance – including car insurance, home insurance, and mortgage insurance. Some of us even insure our cell phones, but many of us forget to ensure our biggest asset: our ability to earn an income.
Protecting your ability to earn an income is the main reason why you should consider including life insurance in your financial plan. It is also the most tax-efficient planning tool you can have to leave money behind for your family and your loved ones.
As business owners, we work hard to build up our business and earn an income so that we can have the desired lifestyle that we want. For us to really calculate how much life insurance you should purchase, we first have to calculate how much the lifestyle that you’re trying to protect will cost you.
HOW TO CALCULATE HOW MUCH LIFE INSURANCE YOU NEED
There are two things that you need to calculate when you’re thinking about the total amount of insurance that you need. The first is the financial commitments you have that could be passed to your family, and the second is the ongoing income you want to keep for them.
1. Calculate your financial commitments
Your financial commitment you’d like to be covered by your life insurance can be calculated by adding up the following:
Calculate the total amount of savings required to pay for things like education or vacations that you want to provide for your children, family members, or loved ones.
Calculate the total amount of debt (outstanding mortgage balance, credit cards, lines of credit, student loans, car loans, business loans, etc.) that you would want to pay off.
Distribution of assets:
Create a plan for dividing the value of any assets (property, vehicles, etc.) that you would want to leave to your children or family members.
Estimate your funeral costs, some of which can be passed through the life insurance and not out of the estate or out of your pockets.
Life insurance as a tax-planning tool:
Life insurance is the most effective tax planning tool to leave money behind for your loved ones. It’s a tax-free payout to your families and you do not have to declare it as part of your income or pay a huge tax bill.
You might not realize this, but the highest tax bill in our lifetime would be the year that when we pass away. Because we have to realize all of our assets and all of our income in one go. So it is always the cheapest and most effective way to pay off that tax bill.
2. Calculate the ongoing income required to support your family
How much income and for how long would you like to provide for your family? As financial planners, we have a tool called a time value money calculator that can help to determine the exact amount of money you’ll need if you want it to work out the exact dollar and the time period you want to provide for your family for.
But if you are just starting out right now, we recommend using what is known as the “10 and 20 times income rule”.
The 10 times income rule:
If you’re earning $100,000 right now you might want to completely replace that income with return on investments. Let’s say your investments earn a 10% annual rate of return. You would now need a million dollars, which is 10 times your salary to earn the same $100,000 per year.
The 20 times income rule:
If you want to be more conservative you would use the 20 times calculation in case your investment doesn’t always earn a 10% annual rate of return. What if it gets a 5% rate of return? Then you would need 20 times your income in order to generate the same $100,000.
DETERMINING YOUR TOTAL INSURANCE NEEDS
By adding up your financial commitments and the ongoing income you need for your family, you’ll be able to determine your total insurance needs.
It’s important to note that life insurance isn’t a one size fit all solution. Just because you and your friend are in similar scenarios and are in the same business, making the same income, you may have very different life insurance needs. That’s because it depends on what your goals are and what you want to do for your family and your loved ones.
So don’t take advice from your family or your friends, speak with a professional about how to calculate the life insurance need that you will need that is best suited for your family.
Life insurance is the most tax-efficient way to leave money behind for your family, and it will help you create the legacy that you desire to protect the lifestyle and the dreams that you’ve created. Remember to review your current policies first, consider the reasons why you need life insurance in the first place, and re-evaluate if it’s still the right financial plan for you.
If you want to learn more about incorporating life insurance into your financial plan, book a call and we’d be love to run you through our full financial Blueprint process.