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This will be the first of a three part series on life insurance. Part I, presented here, will show a formula as to how much life insurance you really need; Part II – looks at whether you need term insurance vs permanent insurance; and Part III – discusses which type of permanent insurance is best. Here is a hint, if you have the wrong type of permanent insurance, you could be sitting on a financial time bomb.
Part I: How much life insurance do you really need?
First when it comes to life insurance, there are essentially two main rules that need to be remembered:
- Rule 1: Life insurance should be purchased for only two reasons. The first reason is to avoid a financial loss of income. The second reason is to leave a bequest to a college or other institution.
Sandy’s elaboration: Thus, having life insurance on kids is ridiculous unless the parent is being supported by the kid.
- Rule 2: Generally with the exception of annuities, insurance and investments don’t mix especially because of the high costs and poor returns of life insurance. If you want insurance, it should be gotten because you will need the insurance and for almost no other reason, although I will be getting into one reason that won’t involve a need for the insurance per se.
There are two approaches. The first, which is both easier to figure out but much less reliable is called the salary approach. Most experts recommend at least 5 to ten times the yearly salary of the person being insured. Thus, if you make $60,000 per year, you would get life insurance covering you for between $300,000 to $600,000.
The problem with this approach is that it doesn’t take liabilities or future obligations, such as future college expenses, into account. This is why I recommend the comprehensive approach. Here is the formula:
- Add up:
• Current amount of liabilities including home mortgages
• Expected amount of future liabilities such as college funding and charitable bequests
• You current income or current yearly living expenses divided by a conservative interest rate of 3%
- You would then subtract from this number:
• Any current savings (stocks , bonds, pension assets, IRA assets etc.)
Here is an example: Let’s say that you have a current mortgage of $300,000. In addition, you will have two kids going to college in eight years. I figure that the cost will be about $300,000 in total (room, board, books etc.) for both kids combined. Finally, let’s assume that you are earning $75,000 a year. If I take the $75,000 and divide by .03, this would require 2.5 million alone. If I add all of this together, my life insurance need before taking savings into account would be 3.1 million dollars, which is a HUGE difference from the salary approach.
NOTE: This 3.1 million is NOT a permanent need. As you build up savings and build up your IRA, you would need less insurance. Likewise, as some of the future obligations go away, such as mortgage payoffs or kids finishing college, you might also need less insurance. in the future.
Material derived from my book, “Achieve Financial Freedom: Big Time”
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