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Why you can't "rule of thumb" life insurance

Why you can't "rule of thumb" life insurance

| May 02, 2016
Life Insurance

"A son can bear with equanimity the loss of his father, but the loss of his inheritance may drive him to despair." - Niccolo Machiavelli

Broken thumb: Have at least 5x your income in life insurance. I’ve seen this rule of thumb vary significantly. One company lists 5-7x your annual income, another states life insurance needs to be at least 7-10x. Recently I even heard the rule is to have 500k per family member plus debt. I could poke a thousand holes in that one… While having a minimum amount of life insurance may seem like sound advice, ultimately it’s not that easy. The proper rule of thumb for life insurance should be: it depends. I will highlight three major contributors to life insurance need.

Worth more dead than alive – debt usually haunts our survivors when we die. While the value of the debt often declines over time, burdening your loved ones with our debt load can be salt in the wound of a grievous loss. This very basic coverage presents a clear and definable insurance need. Say you have 50k in credit card debt and 200k left on your mortgage in a 20 year note. Debt alone, purchasing 250k coverage on a 20-year term insurance policy makes sense.

Filling the fridge – Income replacement is where the rule of thumb goes the most wrong. Why 5-10x our income? Perhaps it’s just easier to be arbitrary? Here’s some math. Assume $100k income, our spouse doesn’t work and we have 2 kids. At 10x income, that’s $1,000,000 in life insurance. We may fall woefully short protecting our family’s standard of living. $1 million may afford somewhere around 40k per year using the 4% rule. Now let’s consider the non-working spouse. There’s no number to multiply. What then? Will you be able to support the family without your non-working spouse? Replacing that value is much more difficult than a simple multiplier!

The kids need to be smarter – One of many insurable obligations most build up for the future is putting the kids through college. With term insurance, this can be very affordable so why not? Two considerations. First, college costs are inflating very quickly, and an in state college in 18 years from now could cost upwards of $300k to put one kid through college. The second, you need to plan for college well ahead of time. Buying life insurance for college planning means you have to die to pay for it. What if you live??? Education funding can more achievable if done with enough time. Without planning, education funding can be unbelievably expensive to our retirement if we pay out of current income. Please read Forsaken for College if you haven’t already.

Moral of the story, the answer to how much life insurance you should buy is that it depends. Life insurance isn’t a sliding scale. It is a very important protection for those of who need it and a pointless expense for those who don’t. It takes some planning to figure out what’s going to work. Working with a professional who builds it into a financial plan is a good starting point to purchasing the correct coverage.
Make it a great week!