Life insurance is for income replacement.
It’s that simple. Forget complicated calculators that include mortgage payoff, children’s education, inheritance, and definitely stay away from insurance salesmen that start talking about life insurance as an investment!
You want a term life insurance policy.
Stay away from words like whole, variable, universal, and permanent. These types of policies are basically term life insurance policies with some type of investment feature added. They either have really high expenses or offer mediocre long-term investment returns or both!
So now that you know you want a term life insurance policy and that your purpose is income replacement, there are just 2 simple steps:
Step 1: Calculate the amount of life insurance you need to replace your spouse’s income
Please note here: if you are single and have no children, then no one is depending on your income so there is no need to replace it! Get rid of any policies you have and use that money to invest.
Start with the amount that your spouse makes. You can use after-tax dollars since life insurance benefits aren’t taxable. However, you want to include benefits and retirement contributions since you would likely need/want to continue those.
So, if your spouse takes home $8,000/month, but is also paying $500/month for medical, dental, vision, etc. and contributing $1,500/month to 401(k), then you want to include those and replace $10,000/month or $120,000/year.
Now that you have the income figure to replace, how do you calculate much insurance you need?
Well, a guy named William Bengen came up with the 4% Rule. It basically states that you can withdrawal 4% from a diversified portfolio and never run out of money.
So, if you stick with Bengen’s 4% rule, you simply divide that annual income of $120,000 by 4% = $3,000,000. Or if you want to be a little more daring, you could plan on 5% withdrawals = $2,400,000.
It sounds like a ton of money and it is, but that’s what you need to replace a $120,000 income indefinitely. You can subtract any savings you already have from the above numbers, though. So if you have $300,000 in retirement accounts, then you can subtract that amount.
Step 2: Now that you know the amount you need, you need to figure out how long you have the income replacement need.
This one is fairly simple too. You either need the insurance until you have the amount saved to replace your income (i.e. $3 million from our example above) or until you would stop working and not have an income to replace.
If you’re 50 and you plan to work until you’re 65, then you need a 15-year term policy. If you’re 40 and you plan to work until you’re 70, then you need a 30-year policy.
Of course, if you build up your investments to the point that they equal your life insurance policy, then you can just stop paying the premiums and let the policy lapse. You are now self-insured! This is where we all want to be.
You are now self-insured! This is where we all want to be.
And this is another reason why you don’t need permanent insurance. You only need life insurance to replace lost income from a premature death. There is no risk to insure when your spouse is 80 and retired.
Let’s do a quick recap:
- Life insurance is for income replacement
- Term life insurance is best
- Don’t mix insurance with investments
- Calculate life insurance need by dividing annual income needed by 4% (.04)
- Structure the term of your life insurance policy to coincide with wealth goal reached or retirement