INTRODUCTION
Life insurance is a unique product. Like other insurance products, its primary purpose is to protect against loss. But unlike other kinds of insurance products, life insurance isn't for you; it's for your survivors. Life insurance has no uncertainties; if you're covered by a life insurance policy — and the company holding the policy has the resources to pay — you can pretty much bet that someday your survivors will receive a benefit. Knowing how much life insurance coverage to buy isn't an easy decision; evaluating a car or a house is fairly simple, but how do you figure the value of your life?.
CHAPTER 1
HOW LIFE INSURANCE DIFFERS FROM OTHER TYPES OF INSURANCE
[1] Dispelling life insurance myths
[1] Looking at the purposes of life insurance
Life insurance is simple, right? You buy a policy to protect your family, you die, your family gets some money. Simple. Direct. Easy. Not so fast. Life insurance is much more complicated than that. This chapter describes some of the myths that surround life insurance and takes a look at the main purposes of having a life insurance policy — not just as income for your survivors, but also as part of your investment portfolio, as a tax shelter, and as part of your estate planning. Myths about Life Insurance The following sections work to dispel the three main myths about life insurance.
Myth 1: I only need life insurance if I have kids
Most people think that they need life insurance only if they have a family — to ensure that their survivors aren't left hanging if they die prematurely. Life insurance is important for several other reasons, which you can read about in greater detail later in this chapter. Briefly, these other purposes are income replacement for a spouse to help him or her through a difficult adjustment period, as an investment, as a tax shelter, and as an estate planning tool.
Myth 2: Life insurance is a bad investment
Life insurance may not be the most profitable investment you can make with your money, but rarely is it a bad one. If you measure an investment only in how much you get in return, life insurance may or may not be a good investment. When you buy a life insurance policy, you put money into an account that will pay your survivors that same money, a portion of that money, or that money plus more when you die. If your survivors get more than you put in (or more than what the money could have earned elsewhere), life insurance is a good investment. If your survivors get less, it isn't such a good investment. However, life insurance is much more than return on investment. Life insurance provides
[1] Protection for your dependents
[1] Peace of mind for you
If you're looking for a pure return on capital, you can find many more lucrative investments — even tax-deferred or taxfree options — that can yield considerably more than your life insurance policy. But the primary function of insurance is not as an investment but as protection. No other investment can offer the same amount of protection.
Myth 3: Life insurance is unnecessary for older people
Not very long ago, older meant "over 50." But many people need life insurance at 50, 55, 60, or 65. Age is not always a reason to abandon life insurance. Even so-called "older" people may need income protection for their survivors if these heads of household or primary caregivers die prematurely. People in their 50s and 60s (and sometimes into their 70s) are in their peak earnings years and have family responsibilities. You may want to give your loved ones the time to adjust to your death without having to change their normal standards of living. Today, many more people in their 50s and 60s are still supporting young children. If a woman has a child when she's 40 or 42, for example, that child won't finish college until Mom's at least 62. Or suppose you have a non-working spouse and you die at the age of 60; he or she may not be able to find a job that brings in a comparable income to maintain the same standard of living. Many older people actually need more life insurance for a number of reasons:
[1] You may have less time to make up for the loss of income.
[1] You may find that inflation has cut into the value of the life insurance benefit.
[1] You have a greater need for estate planning as you get older because you have less time to carry out your plan.
[1] You have a greater need for tax planning as you age because you'll most likely earn more, and life insurance can play a significant part in your tax planning.
The Purposes of Life Insurance
The number one reason to have life insurance is, obviously, to protect your beneficiaries if you die prematurely. That's clear. Every other reason is secondary — although for some people, the other purposes can take on greater importance in certain situations.
Providing protection for beneficiaries
Protecting your survivors means replacing the income you bring in if you die prematurely. If you have children, you probably spend your earnings on the costs of bringing them up. If you die, your life insurance death benefit replaces those earnings so that they won't have to suffer financially. If you have a mortgage on your house, a life insurance death benefit can help your family stay in their home if you die. Life insurance can help you overcome the difficulty of having to totally change your way of life because you lose half or more of your income. Lastly, if you are part-owner in a business, the business may purchase a life insurance policy on you so that if you die, your partner can use that death benefit to buy out your share of the business from your heirs.
Using life insurance as an investment
A second purpose of having life insurance is to use it as part of your investment portfolio. Most financial advisors encourage you to balance your investments so that if one kind of investment goes down (the stock market, for example), another one will likely go up (bonds or real estate, perhaps). By balancing your portfolio and diversifying your investments, you can weather storms in one area by having some assets in the other areas that go up or stay level. 6 CliffsNotes Understanding Life Insurance Some life insurance policies are actually long-term investments, which you can contribute to and withdraw funds from before you die. These so-called cash-value policies — whole life (see Chapter 5) and universal life insurance (see Chapter 6) — are actually savings accounts that accrue a cash value over time and also pay for your protection. Although these policies don't command the highest interest rates you can find, they are untaxed earnings, so you get a higher return than simply putting your money in a savings account on which you must pay taxes.
Using life insurance as a tax shelter
Life insurance can play two roles as a tax-sheltered investment:
[1] The earnings on a cash-value policy are not taxed until you take them out.
[1] The proceeds of a death benefit settlement are not taxable to your survivors. Your cash-value account yields tax-deferred income, which, in effect, increases the yield. Take a look at the example illustrated in Figure 1-1.
Now look at the fact that the death benefit is not taxable to your survivors, and using the same logic, compare the taxable versus the non-taxable return: Suppose that you currently earn $60,000 a year, and you buy a $180,000 life insurance policy to help your survivors through three years without your income. If you die, your survivors get the full $180,000, and none of it is taxed. Although the examples may seem a bit complicated, the point is simple. Because the proceeds of a death settlement and the earnings of a cash-value life insurance policy are both taxdeferred, they serve as excellent tax shelters.
Using life insurance as part of your estate planning
In addition to serving as a tax shelter for you and your survivors, life insurance can also be an important part of estate planning — that is, dealing with how to distribute your wealth after you die. Currently, the federal tax laws state that the first $650,000 in inheritance is federally tax-exempt (that amount increases over the next few years — see Chapter 3). Most states allow the same amount or they have no inheritance tax at all. Realistically, most people don't need to worry much about taxes eating away their estate. Furthermore, most couples own their property and assets jointly, so surviving spouses or owners don't have to pay inheritance taxes, even if the estate is greater than the amount allowed under the law. But if your estate is worth more than the law allows, how do you ensure that your wealth goes to your survivors and not to the government? That's where life insurance and life insurance trusts come.
To do this sort of estate planning, consult an expert who can both counsel you and set up the appropriate vehicles. Briefly, here's how it works:
- You set up an irrevocable life insurance trust, to which you contribute annually. The trust is, in effect, a life insurance policy, which goes to your children or survivors taxfree. You can't withdraw that money for any reason (hence the term irrevocable).
- You and your spouse each leave to your children whatever the law allows at the time, so that money is also taxfree.
- You will the remaining amount to a qualified charity of your choice, which, by definition, is exempt from inheritance taxes. If you don't will the remaining amount to a charity, it is considered part of your estate, and your heirs have to pay taxes on it. In this situation, you take the IRS out of this picture. Using some of your estate, you buy a tax-free life insurance policy so that your heirs get the same amount they would have before any estate taxes — the amount equivalent to your estate. Plus, you donate a large portion of your estate to a charity rather than to the government. The only party that loses is the IRS (and another party wins — the life insurance company, which charges you a significant amount for that policy over a period of years). But your heirs lose nothing! Isn't that the goal of estate planning?
Don't try to wade through this complicated process by yourself. A qualified professional can help you sort through the fine details and prevent you from making a costly mistake.
CHAPTER 2
HOW MUCH LIFE INSURANCE DO YOU NEED?
[1] Determining your personal economics
[1] Understanding your survivors' needs
[1] Dealing with your age
After you understand the purposes of life insurance (see Chapter 1) and decide that you need a life insurance policy, the next step is determining how much protection you should buy. This chapter shows you how to determine how much life insurance you need by explaining how to judge the economic value of your life and your survivors' needs. This chapter also includes a worksheet so that you can make your calculations.
The Economics of Your Life
The basic step in determining how much life insurance you need is to figure out just how much your life is worth. When looking at the economic value of your life, focus on three things:
[1] Your income
[1] Your cost of living
[1] Any uninsured medical costs
Your income
The value of your income is relatively easy to calculate: It's the amount of money you earn, plus the amount of money you'd expect to earn if you hadn't died prematurely. But this figure can be difficult to determine accurately. For one thing, many people have little idea of what they may be earning five years from now, especially younger people who may not have settled into a career yet. Secondly, more and more people change careers (not just jobs, but careers) numerous times in their lives. The average number of careers (again, not jobs) for people is now over five! How can anyone possibly say
what his or her income will be in 15 years? Your best bet when figuring the value of your income is to estimate how much your annual salary is likely to increase each year. When completing the worksheet in this chapter, use an increase of about 5 percent per year. You can see an example of how your salary may grow in Figure 2-1. If you know your salary increases will be more than 5 percent per year, use the higher figure. If you know your increases will be less than 5 percent, use the lower number. You can round off later in the final formula when you determine how much life insurance you need.
Your cost of living
The economic value of your life is not only how much you will be earning but also the cost of living — that is, how much you actually need to live on. More importantly, the cost of living you and your family have set up is really the amount of life insurance income protection you need to purchase — especially because most people tend to spend a bit more than they bring in. In addition, part of your living costs are more than likely going into some sort of savings — to pay college expenses when your children are old enough, to go toward your retirement, to cover a big vacation, and so on. You still want your survivors to be able to save for some of these items (college expenses, for example). But clearly, saving for your retirement isn't something you have to be concerned about if you die. The budget worksheet that follows can help you determine your cost of living. Note that most of your expenses increase over the years due to inflation, if nothing else. On the other hand, some expenses may decrease or be eliminated because they are no longer necessary. One of these, of course, is the life insurance premium. But some other examples of unnecessary costs are clothing, food, and other expenses for children who will eventually be out on their own and paying their own expenses. Note also that this budget doesn't include unusual expenses, either planned (such as college expenses or weddings, unless your budget includes saving for them) or unexpected (such as medical emergencies or funerals). 12 CliffsNotes Understanding Life Insurance And note, finally, that the budget worksheet doesn't include paying off any large debts which you're currently paying over
time. If you want your life insurance to pay off some or all of these debts, make sure that you increase the death benefit to cover these amounts so that your survivors no longer have to include the debt payments in their budgets.
Your uninsured medical costs
Uninsured medical costs are one of the biggest potential drains on a family budget. Including uninsured medical costs in your family budget is crucial because health insurance terms, benefits, and regulations change so quickly. Moreover, because life insurance protection is related to your health, by definition you want to be certain that your survivors can pay for your medical costs should you die. So after completing the budget worksheet, add a flat amount at the bottom to pay for these unexpected and uninsured medical costs. How much to add? Good question. The figure you decide
on will vary depending on what kind of health insurance you have now. If you belong to an HMO, most of your medical expenses are covered. On the other hand, if you have a private plan in which you pay 20 percent of the costs, your portion is likely to be far greater. Only you can really estimate this amount. However, most experts say that you should always maintain approximately three months worth of living expenses available, so try adding that amount to the bottom of the worksheet as your emergency fund to cover these uninsured medical costs.
Budget Worksheet: Expenses
Fixed Expenses
Household: Rent/Mortgage ______
Property Tax/Escrow ______
Lawn and tree service ______
Domestic help ______
Insurance: Homeowners/renters insurance ______
Life insurance ______
Automobile insurance ______
Health/disability insurance ______
Loans: Automobile ______
Other fixed loans or credit ______
______
______
Total Fixed Expenses ______
Variable Expenses
Household: Utilities (gas, electric, water, sewer) ______
Home repair ______
Telephone ______
Groceries ______
Transportation: Auto licenses and registration ______
Auto gas and oil ______
Auto repair ______
Parking ______
Medical: Doctors/dentists ______
Prescriptions ______
Over the counter drugs ______
Clothing: Laundry/cleaning ______
New purchases ______
Personal Care: Toiletries ______
Haircuts/styling ______
Miscellaneous ______
Personal: Dining out ______
Entertainment ______
Gifts ______
Subscriptions and books ______
Donations ______
Miscellaneous: Bank charges ______
Investment expenses ______
Legal and professional fees ______
Taxes ______
Other ______
Total Variable Expenses ______
TOTAL EXPENSES (fixed plus variable) ______
Budget Worksheet: Income
Fixed income
Wages ______
Dividends ______
Certificates of deposit ______
Fixed interest-bearing bank accounts ______
Rental income ______
Child support/alimony ______
Variable income
Capital gains/losses ______
Budget Worksheet: Income (continued)
Variable income
Variable-interest bank accounts ______
Tax refunds ______
Gifts ______
Other benefits (assign monetary value) ______
Total Variable Income ______
TOTAL INCOME (fixed plus variable) ______
Your Survivors' Needs
The next step in determining how much life insurance you should buy is to decide just how much your survivors need. You need to account for four expenses that your survivors will need to cover:
[1] Estate taxes
[1] Probate costs
[1] The cost of dying
[1] Planned future expenses
Estate taxes
Depending on the size of your estate, your heirs may have to pay taxes on the amount they inherit. If your entire estate goes to your spouse, he or she faces no tax consequence, regardless of the estate's size. If, however, your estate goes to other beneficiaries and your estate is larger than the amount allowed under the tax law, your heirs have to pay taxes on the balance over those amounts. Although the 1999 figure of $650,000 may seem 16 CliffsNotes Understanding Life Insurance huge to you, many people own homes that have increased in value so much that the equity in their home is over the limits allowed by federal inheritance tax law. In these types of situations, heirs may have to pay a significant sum in taxes. Quite likely, they won't have the cash or other liquid assets to pay the estate taxes, particularly if the inheritance is in a form that they can't easily convert to cash. In that case, they either have to sell the asset or pay the estate taxes from other sources. You can help your heirs pay the inheritance taxes by buying a higher amount of life insurance (and thus a higher death benefit). Be sure to include an amount to cover the estate taxes when you complete the worksheet to determine the amount of protection you need.
Probate
Probate is the process by which your estate is accounted for, all debts and taxes are paid, and whatever is left over goes to the rightful heirs. At this point, your will is officially registered and the executor of your estate is given the legal right to dispose of your assets. Many executors choose to get assistance from an attorney to handle the financial affairs (although doing so isn't required). Depending on the size of the estate, an attorney may charge $2,000 to $3,000 to handle probate. You may want to increase your life insurance death benefit by that amount to take care of the probate expenses. Dealing with estates and probate can sometimes get fairly complicated. Speak to an attorney before handling them yourself.
The cost of dying
The cost of dying refers to the expenses of funerals, burials, and the disposal of your body. How much you pay for these expenses is more than likely up to your survivors. The cost of funerals varies enormously. But on average, burials cost between $5,000 and $10,000. Cremations cost considerably less, from $2,000 to $5,000. When determining the amount of life insurance to purchase, consider including an amount in the death benefit that can cover the cost of the funeral. Talk with your spouse, if you have one, or to your parents if they are your survivors, or your children if they are old enough, about funeral expenses. This conversation may not be easy, but be persistent so that they can honor your wishes (and make theirs known) should you die. Many funeral homes won't require payment directly from your survivors but will allow and will help you arrange to be paid directly from the life insurance proceeds.
Future expenses
When calculating the needs of your survivors, building in expenses that you know will occur is extremely important. These expenses are usually the largest factors in determining how much insurance to buy. One of the most obvious of these planned future expenses is the cost of attending college. Build in a cost of about $80,000 to $100,000 per child in today's dollars. Of course, the actual amount your child needs will probably be considerably more later on, which is taken into account with the inflation factor in the worksheet or in the insurance policy. 18 CliffsNotes Understanding Life Insurance The amount of life insurance you buy now is the amount your survivors need if you die soon. If you're worried about inflation eating into the death benefit, you can buy an insurance
policy in which the death benefit increases in value. You can read more about these kinds of policies in Chapters 5 and 6. You may be aware of other expenses that your family will incur, such as orthodontia, summer camps, special classes for your children, or special medical needs. You should build these expenses into the worksheets. Additionally, you can count on at least one or two of those unexpected expenditures that come up, including a new roof for the house, a new car, and medical emergencies for which your health insurance doesn't pay the entire cost. When you complete the budget worksheet, build in some "fudge factor" — about 10 percent of your annual income is good — to account for these unplanned costs.
Age — Yours and Your Survivors'
One of the determinants of how much life insurance to buy is age — your age and the age of your survivors.
Life expectancy
The amount of insurance you purchase depends very much on your life circumstances, what your style of living is, how much your survivors need, and what lies ahead for your beneficiaries. If you are 30 years old and in good health, the chances are great that you will live another 50 years or more. As medical advancements continue, your life span may be even greater, assuming that you're not hit by that proverbial truck. Chapter 2: How Much Life Insurance Do You Need? 19 Your life span affects your life insurance needs in these ways:
[1] The younger you are, the longer your survivors are going to need income replacement, the more dollars you need to put away for future expenses such as your children's education, and the more likely it is that your living expenses are lower.
[1] The older you are, the less chance your spouse has to plan for his or her retirement, the less likely it is that your survivors will have to depend on you to fund a college education, and the more likely your spouse is to need medical, skilled-care assistance, or nursing home care.
Cost of premiums
The age at which you buy life insurance relates directly to the cost of your premium (the amount you must pay for the coverage). The younger you are, the cheaper the premium. A 38- year-old male buying a five-year, term life insurance policy with a death benefit of $100,000 may pay only about $175 per year, while a 48-year-old may have to pay about twice that amount for the same coverage. If, however, that 38-year-male old wants to buy a cash-value life insurance policy — one that not only provides a death benefit when he dies but also builds some value that he can use when he retires (or that adds to the death benefit) — he may have to pay about $600 a year, about three-quarters of
which goes into his cash-value account. When determining how much life insurance you need, you have to take into account how much life insurance you can afford. The cost of insurance goes up every year as you age because your life expectancy is lower and the insurance 20 CliffsNotes Understanding Life Insurance company knows it has fewer years before you are expected to die. Decide how much you can afford to pay per year and work with that amount to determine how much life insurance to buy. One way to estimate how much your premiums will be in five or ten years is to find out what the premium would be now if you were five or ten years older. Doing so gives you
the price in today's dollars. You can add about 15 to 20 percent more for five years and about 40 to 50 percent more for ten years to account for inflation.
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