If you were to pass away suddenly, would your family be financially secure?
While this isn’t an enjoyable topic to consider, many people will do everything possible to avoid this subject altogether until it’s too late, but the truth is that life. So if you’re a provider of income or support for others, then you need to make plans for those “in the moment” events as part of your overall financial management process.
Before we get into the nitty-gritty, let’s hit you with some general rules of thumb that most people find very useful. One of the best places to start in determining how much life insurance to have would be approximately 12 times your salary.
Now I know when you first hear that number it may seem like a random number plucked out of thin air, but actually, it has a pretty logical basis. If you were no longer available, then the individuals that rely on your income (living expenses) would still need an income to pay those bills. As such, your family would use the proceeds from your life insurance payout to invest in the market, and the income generated from that investment would basically replace what you would have provided for them.
So think of your life insurance policy as a means to continue providing your family with financial stability, regardless of your current situation or future plans.
When you have life insurance, you are in a contract with the insurance company where you pay them a price regularly (usually monthly) and in return, the insurance company provides a sum of money to a person of your choice when you die while the policy is still in effect. That beneficiary could be your spouse or children or anyone else you are concerned about financially. The purpose of life insurance is so that the people who are important to you have some time after you die to adjust to life without your income.
In reality, the majority of people purchase life insurance to have peace of mind.
There is not one type of life insurance; there are several different types available today, but there is one type of life insurance that is typically considered to be simple and cost-effective, which is a term life insurance policy.
A term life insurance policy provides coverage for a specific amount of time (typically 10 years, 20 years, or 30 years); however, if the insured individual dies during that period, the policy will pay a death benefit; if the insured individual outlives the policy, the insurance company will not pay any benefit to any party.
From the design of the policy and comparative rates with more expensive types of life insurance policies, term life insurance policies are generally considered to be cost effective and simple. For this reason, many financial planners recommend term life insurance policies for basic coverage.
Now, let’s look at how this “12 times your annual income” becomes a real figure
Take a person earning $50,000 annually multiplied by 12, you would get $600,000; that is the total insurance coverage you would want.
If you take that amount ($600,000) and put it into a diversified investment that tracks the overall market such as an index fund, you could generate enough income from it each year to replace the lost wage of the deceased.
Generally, the stock market has earned an average of about 10% annually, so with an approximate estimate, you will earn approximately $58,000 each year from your $600,000 investment before you have to start to reduce the original dollar amount.
Therefore, you would be able to live off the growth from your invested money while still having access to the original balance.
Yes, there will be years that the market goes down; this example provides an illustration of why higher amounts of insurance are so important for your financial future.
Some wonder why the recommendation is for “12 times annual income” rather than “10 times annual income”.
Most life insurance policies have a term of many years, not just a short time. As time goes on, you will likely see your salary rise and the cost of living increase as well. Choosing a little higher amount of coverage will take into account the potential long-term changes you will experience over the next 10-20 years.
The difference between the monthly premiums of those two coverage amounts is normally less than you would expect too.
Now think about people who do not get paid for their time, such as a stay-at-home parent.
A stay-at-home parent’s situation may make it seem that having a life insurance policy is not needed because there is no official paycheck to replace. However, by thinking like that, you are forgetting about the tremendous value of the work done in the home.
To add financial value, the cost of raising a child each year costs thousands of dollars just for childcare, cooking, cleaning, transportation, and managing the household. It is easy to find the value of each of these areas once you look at everything added together.
The last thing most people think about regarding life insurance is how to go about calculating what your family’s needs would look like if you passed away, but that’s exactly what this process entails.
The first step in calculating your family’s needs would be to evaluate the services provided by family members at home. If a parent suddenly lost their job (or passed away), and they had to hire all of those services to keep the family running smoothly, the cost would be substantial. Therefore, many stay-at-home parents will also purchase additional insurance coverage for themselves.
Once you calculate the services your family provides, the next step will be to estimate how much it would cost to replace those services for one year. After you complete that task, multiply that number by 12.
When you think about life insurance, you are most likely thinking about something you do not like to think about – your worst-case scenario.
FYI, financial planning involves more than just saving for retirement and investing for the future; it usually also involves protecting your loved ones.
Lastly, when looking at life insurance from this perspective – protecting the people who depend on you, it certainly isn’t about the death of the insured person. It should be viewed as a way to help your family continue to thrive regardless of the outcome.
