I'm a financial planner, and I always recommend life insurance to 4 types of people
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- If anyone depends on you financially, it's probably a good idea to get life insurance. As a financial planner, there are four groups who always need this type of coverage.
- Parents and couples who share finances should get life insurance to cover their loved ones in the event of one person's passing.
- Homeowners should also get life insurance to cover their share of the mortgage, and business owners should get enough life insurance to cover their share of the business.
- Policygenius can help you compare life insurance policies to find the right coverage for you, at the right price »
Life insurance is traditionally purchased with the intention of providing an income stream for your loved ones in the event that you die unexpectedly. Life insurance proceeds pass to any named beneficiaries tax free and, at a minimum, should cover your children, your spouse, and anyone with whom you've accumulated a significant amount of debt or equity.
As a financial planner, I always recommend life insurance to four types of people.
The very first step in the process of purchasing life insurance is to determine who it should cover and what life events or expenses you would like it to cover them for. If you have children, you likely have big plans for them and what they will accomplish by the time they are adults.
You may not only want to provide for their college education, but for their primary and secondary schooling as well. You would want to do your best to estimate what those costs will be over 18 or 22 years with inflation. Then, purchase a policy that spans that entire time period.
Couples who share finances
If you have a spouse, you have likely built up a lifestyle that is based on your combined incomes and your collective buying power. Conversely, if you have a spouse who does not work outside the home or they earn significantly less, you may want to provide enough of a future income stream that they are still able to meet their basic needs if you were the first one to go. In either case, you will want to estimate what your income contribution to your household is today, as well as what it is expected to be in the near future.
There are several methods that the insurance industry uses to determine the right amount of coverage for an individual or family. However, a widely accepted rule of thumb to determine a minimum coverage amount is to take a person's after-tax income and multiply by 10. Though the equation is not perfect, that would reasonably imply that at a minimum, you have provided 10 years of income replacement for your loved ones.
In addition to replacing your income, you would want to have enough life insurance in place to pay off any large debts you are responsible for, such as a mortgage. Whether it's a married couple, siblings, or anyone else who purchased a home together — assuming they bought the home based on both incomes — it is a good idea to have life insurance coverage in place to protect both owners from a loss of the other party's income.
A simple solve for this is to purchase a life insurance policy on each borrower for 20 years, equal to 50% of the outstanding mortgage. On any traditional 30-year fixed-rate mortgage, the majority of each monthly payment goes to interest in the first five years of the loan. This means that you will not start knocking off much of the principal until after year five. And by year 20, you would have likely paid the mortgage down enough that if you were to lose your co-borrower, you could refinance the mortgage to something manageable on your own.
Beyond replacing your income and settling your debts, you would also want to have enough life insurance coverage to protect your interest in any illiquid assets, such as a privately held business.
As anyone who has ever built a business knows, it usually takes pouring every available dollar you have into that business for years before you are able to draw an income from the business just to cover your living expenses. An even more tricky feat is the challenge of extracting any value that you have built up in that business by turning it into actual dollars. And all along that journey as an entrepreneur, it is important to carry enough life insurance coverage to be sure that your estate receives the value of your life's work should you perish prior to a successful exit of the business.
What was challenging for one entrepreneur becomes infinitely more complicated when there are partners involved. If a partner or key employee in a business were to die unexpectedly, it would pose a substantial business interruption for the rest of the team and their ability to perform their duties as normal. And if the business did not have the necessary cash available to buy out the deceased partner's spouse or children, they could be forced to sell.
Each partner having his or her own life insurance policy, owned by the business and covering their respective ownership share, would ensure that their heirs could extract their fair share of the business's value without disrupting normal operations or forcing a sale among the remaining owners.
Malcolm Ethridge, CFP, CRPC, is an executive vice president and fiduciary financial adviser with CIC Wealth Management.
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