Life insurance can be an important part of an estate plan, but not for everyone. Many employers include a small life insurance policy for their employees, usually just enough to cover burial expenses. Additional life insurance can be useful, especially for the parents of young children or those who support a disabled spouse or child. However, you do not want to buy more insurance than you need. So how do you know whether you need it, and if you do, how much to buy?
Whether you and your family could benefit from life insurance depends on several long-term and short-term factors. The questions below can help you determine whether life insurance may help provide financial stability for your family.
1. How many people depend on your earning capacity?
If the answer is "none," you probably don't need life insurance.
2. How much money would your dependents need for living expenses?
There are several ways to determine this number. One is to take your annual salary and multiply it by 10. Why 10? Historically, the stock market has grown an average 10% every year since 1928. If your dependents invested the total life insurance, they should receive your annual salary in interest yearly. You may also want to take into account any property that would be inherited and deduct the value of its sale, as well as any other potential sources of income for your dependents (for example, gifts from grandparents who may step in if a disaster occurred). For many of my clients, $1-2 million per parent is a typical amount.
It is also important to count the value of any stay-at-home parents in this equation. If that person suddenly passes away, there will be the additional costs of child care, home cleaning, meal preparation, and so forth.
3. How long will it take for your dependents to become self-sufficient?
If your kids are young, you may need life insurance for 20 or 30 years, long enough to see the youngest through college. However, if your kids are already in high school, a 10-year policy should be sufficient to see them into adulthood.
Let me back up for a minute. I'm talking about term life insurance here, which expires after the term passes. Much like auto insurance, it is only in effect while you have the policy. After all, you don't need car insurance if you don't have a car. That's why it's important to figure out how long you will need insurance and to be covered only for the time in which it makes the most sense. Universal life insurance, on the other hand, is more like an investment or an enforced savings account -- you continue to pay into it throughout your life. When you pass, it passes to your designated beneficiary. It is a gamble whether you will end up paying more than the amount of the policy (if you live a long time) or less (if you die young), and it is debatable whether you would be better off investing that monthly premium in an investment account. For these reasons and more, most financial planners recommend against universal life insurance. If you're interested in learning more about universal life insurance, however, I encourage you to talk with your financial adviser. For most of my clients, term-life insurance is the best fit for safeguarding the future financial stability of their children.
Now let's talk about your family's short-term needs.
1. What assets will be available to help with your families immediate financial needs?
Do you have a joint checking account? Can your spouse or the guardians for your kids access your bank accounts? Are most of your assets liquid (meaning they can be converted to cash easily) or not (like real estate, coin collections, etc)?
2. After you die, how long will it take for your assets to transfer to your heirs?
While probate is not expensive, it can take months before payments can be made out of your estate. While there are court orders that can release family expenses early, life insurance can also help with immediate expenses.
3. Will your estate owe substantial debts and taxes after your death?
This is also mostly an issue if there are not sufficient liquid assets to deal with immediate financial needs. If your estate is mostly non-liquid (real estate, business ownership, jewelry), they may be sold off quickly but for less than they are worth in order to cover those immediate financial needs. While debt may not be a significant concern for your estate, it is worth thinking about now.
Lastly, let's talk a bit about the impact of life insurance on your estate. The reason why life insurance can help with immediate financial needs is because it transfers to your beneficiary outside of the probate process. While your real estate and bank accounts are subject to probate proceedings that can take months, your life insurance will pay out to your beneficiaries within weeks (sometimes within days).
However, for the purposes of estate taxes, life insurance is included. As I've said before, if you own a home in King County and have life insurance, you will probably exceed the estate tax exemption. The exemption amount changes every year -- for 2018, it's $2.129 million. If you're in this boat, I recommend consulting with an estate planning attorney.