Life Insurance and Your Financial Plan

A good financial plan will incorporate life insurance as a core pillar.

I often tell clients to think of life insurance similar to car insurance. An expense you have to pay and hope you never have to use.

So, if you hope you never have to use it can you do without it? For most people in the world that answer is most definitely no. There are some people who have accumulated enough wealth that they will be able to self-insure.

For most people though this is a necessary expense to provide protection for loved ones should something happen.

Reasons to Have Insurance

Provide Income Replacement

The most common reason to buy life insurance is to replace your income.

Think about it, if something happens to you your loved ones no longer have your income to sustain their lifestyle. Buying life insurance gives your beneficiaries a tax-free death benefit to replace your income.

How much you should by is determined by your unique situation. Younger couples with a lot of debt, a few kids, and high expenses need more than someone who is just looking to pay for their final expenses.

A general rule of thumb I follow is as follow.

• 30-40 years old need 8-10 times annual income replacement
• 40-50 years old need 6-8 times annual income replacement
• 50-60 years old need 3-6 times annual income replacement
• 60+ years old need 1-3 times annual income replacement

Let’s assume I am onboarding a new client. They are 35 years old have a few kids and make a decent income of $100,000. I would recommend somewhere between 800k-1M in insurance coverage. Even more if they have significant debt.

Protect Cosigners

A cosigner is someone who signs your loans as a guarantee to a bank that you will repay. If you fail to pay the bank can go after your cosigners to make payment. If they don’t, their credit is negatively affected.

For clients who have cosigners on their loans I normally recommend that they take out enough insurance so that the cosigner can pay off the balance. This protects them in the case of the unexpected.

One caveat here is to understand the type of debt you have. If it discharges at death and the cosigner is not left on the hook you do not need insurance for it. Federal student loans are a good example of this. Private loans however are not and need to be accounted for.

Leave a Legacy

Some people just want to leave money to loved ones. They do not need insurance, but it is important to them that they leave others in a better place.

So, they may take out a policy specifically for that reason. Life insurance proceeds are tax free under certain thresholds. This is a great way to leave people money and leave out Uncle Sam.

Give to Charity

Other individuals want to leave money to their favorite charity.

Perhaps they want to leave money to their church or school. Or to a local soup kitchen.

Regardless of where they want to leave it, they can designate one or more charities to benefit after they pass.

Business Succession Planning

One often overlooked use for life insurance is in business succession plans.

Let’s walk through an example.

Let’s say that you sell your business for $1M. The buyer is going to pay you in 10 payments, one each year, for the next 10 years.

What happens if that buyer dies in year 4?

If you are uninsured, you may be out of luck. The buyer certainly cannot make payments any longer and there may be language in the contract that prohibits you from receiving your payments.

One way around this as the seller is to buy life insurance on the buyer. If something were to go wrong the seller would receive the death benefit and therefore be made whole on the sale of the business.

This is one way to strategically sue life insurance to protect yourself in business ventures.

Types of Insurance

Term Insurance

Term insurance is the simplest form of insurance.

You buy a specific face amount. This is the amount that your beneficiaries would receive if anything were to happen to you.

You select the number of years, or term, you want coverage for.

Then you pay a premium each year for that coverage similar to how car insurance works.

If you outlive your term, you lose your coverage and will either have to reapply or hope that you are able to self-insure at that point.

This is the cheapest form of insurance and the type most people use to protect themselves.

Whole Life

Whole life insurance is different from term insurance in the fact that it is in place for the client’s entire life.

There is no term where your coverage expires.

There is also a cash value component that acts as an investment vehicle. This portion of the policy grows as the underlying investment grows and also pays dividends.

If you have a whole life policy, you dream of the day that your dividends are able to pay off your annual premium. This is considered a paid-up policy.

The big drawback to whole life is that it is expensive. When you consider the cost of insurance, the investment fees for the underlying investments, and any attached riders the fee can be upwards of 3.5%.

A fee that large can really eat into your long-term returns. But it does provide you protection for your whole life not just for a certain timeframe.

Universal Life

Universal life acts very much like a whole life policy but is much cheaper. Although it is still not nearly as cheap as term insurance.

The biggest difference between universal life and whole life is when it comes to premium payments and investment options.

Premium payments are flexible. Meaning there is some leeway when they can be made and the amount.

Whole life payments are fixed and constant at defined intervals. Universal life requires annual payments, but you can also contribute more to the policy at any point in time. Payments also have an end date. You only have to contribute for a certain amount of time and then you are done. If the underlying investments perform well this is a much cheaper way to insure yourself for life.

Speaking of investments, you have many more options than whole life. In whole life policies the investment companies manage your investments for you. So, you are subject to however they perform.

In universal life the policy holder is responsible for the investment component. Or their financial advisor in many instances. This means they also bore more risk. Because there is no guaranteed component to the investment, underperformance can cause the policy to lapse if the buyer cannot make a payment to keep it paid up.

What Makes the Most Sense?

This is different on a client-by-client basis.

For most people term policies will make the most sense. They provide protection, are cheap, and provide no maintenance outside of the annual premium.

Whole life makes sense for individuals who want to have coverage for their life. They also are looking for tax deferred investment growth. And they typically are a bit wealthier to be able to afford the large premium payments.

Universal life makes sense for many of the same reasons as whole life insurance, but it is cheaper. It is a bit riskier because it does depend more on investment performance, but it is becoming more popular than whole life because of its flexibility.

If you are looking for more info on the difference between whole life and universal life, check out this link.

A Tale of Two Clients

Serving as a Financial Advisor for the past decade, I have had my fair share of insurance conversations.

What I want to do is walk you through two client scenarios that I have seen in the past to help show you how to decide what makes the most sense.

Client One

Client scenario one is a young couple who are well educated, both have master’s degrees, a bunch of debt, and good jobs. They just bought their dream house and have three kids. They each are in their late 30s.

The first thing I did was assess their debt. He had $180k in student loans and she had $220k. They were each the others cosigners on the loans. They also had a mortgage for approximately $700k.

From a debt standpoint he already needed $880k worth of coverage and she needed $920k.

Next, we looked at their income. He made $150k annually and she made $180k annually. He needed between $1.2-1.5M worth of income coverage and she needed $1.44-1.8M in coverage.

Total he needed $2.08M-2.3M of coverage and she needed $2.36-2.72M in coverage.

We decided to purchase a 30-year term for each of them and buy enough coverage to cover their debts and 8 years of income replacement. This cost them each about $2500 annually. So, for $5000 a year they were protected for the next 30 years.

Client 2

Client scenario 2 was a couple who were each in their mid 50s. He was a surgeon, and she was a stay-at-home mom for most of her life and now volunteered at a few foundations.

Because he was the sole income earner, we were concerned with insuring, his life but also wanted the assets to grow tax deferred.

They had no debt, and their kids were in college which they already had well-funded. He planned to work another 10 years, but he could comfortably retire at that point if he wanted to.

The client was maxing out his retirement accounts and HSA. He was looking more for tax deferred investment growth than protection.

He made roughly $500,000 annually and we decided to insure for 3 years of his income or $1.5M.

We ran quotes for a whole life policy and universal life policy. Because he was an aggressive investor who was looking for growth, we ended up opting for the universal life policy. Annually he was saving over $15,000 in premiums and he only needed to make contributions for the next 15 years to have a paid up policy.

Also, over that time his underlying investment continued to grow. By the time he was 75 years old his account value was worth more than his death benefit.

At this point he could really experience the power of a universal life policy. We developed a plan to begin borrowing from the cash value of his policy. This is tax free borrowing. In other words, he could pull money off the policy each year to fund his lifestyle.

We could use this money to supplement his required distributions from his retirement accounts without pushing him up into a higher tax bracket.

A Final Word

No one likes to have a conversation regarding life insurance. It is a rather morbid topic but one that needs to be talked about.

Life insurance has many different uses and provides a huge protection for the unexpected.

To gauge your need for insurance you need to account for your debts, your income and your age. With that information you will be able find the protection amount you need for your life.

From there you need to decide which type of insurance is best for you.

Term is cheap and provides you coverage for a certain period of time.

Whole life provides you with coverage your entire life but is more expensive.

Universal life also provides you with lifetime coverage but is cheaper and riskier than its whole life alternative.

If you are unsure what type of insurance makes sense for you, let’s have a conversation.

One thing is for certain, life insurance is not something to overlook.

It provides you with protection from the unexpected.

It allows you to leave money to someone you care about.

Finally, it is a crucial part to every financial plan.

How does life insurance fit into your financial plan?