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How Much Term Life Insurance Do You Need?





You’re probably assuming that I know the answer to the post title, but unfortunately I don’t have an exact answer.  Like most personal finance issues, it really depends on your current situation.

I believe that life insurance is a means of protection, not a means of making someone rich.  To clarify, term life (not universal life insurance) should be used to protect the people dependent on your cash flow.  On top of that, I feel that people should work towards building their asset base so that they eventually won’t need insurance.  That’s why term life works so well.  It covers you when you NEED the insurance while you’re young, but 20 years down the road hopefully your debt will be low along with enough assets to cover the needs of your dependents (if you have any at this point).

Personally, with both my wife and I working with decent salaries, we don’t “depend” on each other for cash flow.  If one of us were to pass away the only real financial pain we would face would be our biggest debt, our mortgage.  So in my specific situation, I would be comfortable with getting enough term insurance to cover the mortgage.

When we do have children, the whole insurance picture changes drastically.  Now, not only do we need enough term life to cover our debts, but now we need to replace income to raise a child in case one of us passed away.  So how much do we need to cover a child?  Realistically, assuming that the insurance covers all debts, one of us should have no problem raising a child (financially speaking).  However, what about larger future purchases like college/university or the cost of a nanny care to help out with single parenthood?  Perhaps enough  insurance (on top of debt payment) to put a lump sum into a RESP (you can do this with the new RESP rules), and a bit extra to cover other child are expenses.

In conclusion, life insurance is meant to help reduce the financial burden faced by the beneficiary.  With that in mind, you’ll need a lot less life insurance than what most insurance reps will recommend.  However, every situation is different.  If you have dependents, sit down with your spouse and have a chat about the worst case scenarios.  How much would you need to minimize the financial burden in case one spouse passed away?

If you want to get some comparison quotes on term life and auto insurance, check out Kanetix.  I’m all about comparison shopping, and Kanetix provides a free insurance comparison service for both Canadians and Americans.

What are your thoughts on the amount of life insurance needed?





23 Comments, Comment or Ping

  1. term4life.ca is a good website to get quotes.

    How much insurance you should get is a well worn topic. There is a worksheet in “Spend Smarter” book if I recall correctly that can be used for an initial estimate.

  2. FT,
    You also have to consider something else: You and your spouse might have good income and you won’t depend on her income if she passes away. However, You might be afflicted by the loss of your spouse and you might not want to get back to work right away. If you are taking 6 months – 1 year without income, this needs to be taken into consideration.

    You also might want to travel, change house (as it brings too much memories) or modify your spending habits after the loss of your spouse.

    Since you are young and you seemed to look forward a 20yr term insurance policy, you might want to raise your policy amount just in case.

    Cheers,
    FB.

  3. 3. George

    This is indeed a well-worn topic. Problem is, most of the “worksheets” that people toss around aren’t that helpful to somebody’s individual situation. Neither is the advice of insurance reps eager to over-sell insurance.

    The only point I’d make is that some things are often forgotten when figuring out how much you need, such as:

    1) Calculating need based on current pre-tax (gross) income rather than take-home pay. Insurance payments aren’t subject to taxes, CPP, EI, or pension deductions.

    2) Ignoring any death benefits or life insurance that may already be in place through work.

    3) Ignoring any income that could be received from pension assets and RRSPs.

  4. 4. Cannon_fodder

    I’m also assuming that most policies (like mine) are not indexed to inflation. As time has gone on, I’ve needed more insurance, not less. Put those two aspects together and you need to review your life insurance needs as things happen. Fortunately, it has been relatively easy to adjust the policy as life has changed (new children, bigger house, living in a more expensive city, etc.).

    I, too, hope that in about 6 years the need for life insurance will start going down (kids growing up and becoming independent, mortgage retired, etc.)

  5. How much insurance do you need? That is a loaded question.

    Insurance is a personal thing. How do you want things to be for your spouse and children if you are not around? How much money will that take?

    I have delived cheques to a surviving spouse and in most cases there is not enough money. A lump sum can seem like a lot of money but it can go fast.

    I agree, just buy term, it is inexpensive and you can get a lot of it. Most people that buy just Whole life or UL don’t have enough coverage because the premium is too high. Consider the whole life or UL when you are financially set.

    Remember that term insurance is sold in bands and the unit price reduces at 100,000 $250,000 and $500,000. So if you are thinking of getting $200 or $225,000 take a look at the $250,000 premium.

    Also, if “you” are not sure how much insurance you need, error on the high side. If you are doing the other financial planning strategies discussed on this site then an extra 5 or $10 a month on life insurance should not be a big deal.

    Ok, let me have it George, as part of my pratice I do offer life insurance.

  6. 6. Evan

    There is a huge issue that people miss when asking/answering this question….ESTATE TAX

    I am new to your blog but not new to this field (I am the Director of Financial Planning at a wealth managment firm) I have no idea about your (or anyone else’s!) personal situation, however, if you are making good money, have kids, have a business, decent retirement etc etc YOU NEED INSURANCE (Whole life or universal life) to offset the tax due and owing at the time of death.

    This statement may seem oversimplified but it isn’t for instance:

    You and Wife have an estate of $4million – you die leave everything to her ZERO TAX wonderful! but when she dies and leaves it all to the kids in 2012 – you get a million dollar exemption then owe approximately 47% on that remaining 3mil e.g. 1.5 Million LIQUID tax bill, how do you solve for that?

    YUP – UL or WL

    JUST A THOUGHT!

  7. Evan, there is no estate tax in Canada, only probate fees and income tax charged to the liquid value of assets as they are passed on.

    In your scenario, the kids can simply liquify the assets and pay the tax bill. By that point, the kids should be self sufficient anyway.

  8. 8. Evan

    Frugal,

    Youa re 100% correct that is exactly what the kids can do, but why do it!

    You cause a fire sale of assets that may or may not be worth that amount upon death, i.e. the New York Housing market just took a major hit….if you were to sell your “1,000,000″ house it may only go for 800K (housing is down 20% on long island)

    MUCH More importantly, you just handed over 1.5 million dollars to the UNITED STATES Gov’t (you are right i should have specified those tax numbers) when you could have spent a little extra cash on a UL Second to die policy versus term – and saved 1.5 million

    I am more than willing to admit that there is a cross over point, such that, the increase premium invested with a return of X will outweigh the 1.5 liquidity, but more info would be needed.

    I know nothing about Canada estate law (didn’t teach it in law school obviously) but I am sure there is the same basic argument there!

  9. Evan, I agree, if someone is facing a tax issue as descibed they should look at insurance. Unfortunatly, most people won’t be in that situation.

    FT it is not always simple to sell the assets. Plus business owners spend their life creating something and there is often an emotional attachment to the business – They don’t want to lose it to taxes and they want their kids to take it over.

    For the situation described I would look at a solution built arond the 10/8 concept with yearly renwable term. With 10/8 you purchase a UL policy and you are guarenteed to make 8% in the policy if used as collateral for a loan. You borrow at a rate of 10% (no choice – that is how they give you the 8%) which is tax deductible because you invest back into the business or an investment account. You can also use the concept to get money out of the corporation while living.

    This is not for most people. Most policies have a minimum premium of $25,000/yr for 4 years or an annual income of $250,000.

  10. “Well worn”? – it’s not well worn until I’ve blogged about it :)

    My approach to life insurance planning is the same as for retirement planning. You need to determine the financial goal – ie what kind of lifestyle does the survivor want to have? Then you need to figure out what the annual income is necessary to provide that lifestyle. I like using the 4% rule to determine how much of a nest egg is required to provide $x of income.

    In our case we’ve determined that we want enough money if I die so that my wife can get by reasonably well without working. Our current expenses not counting mortgage is about $32k (which will probably go down if I’m not around). Assuming she will need $33k of gross income (mostly cdn div income) (according to taxtips.ca) then she needs a starting portfolio of about $800k. With a current mortgage of $180k and rrsp of $230k, that means we need $760k of insurance to meet this requirement. ( $760k – $180k + $230k ) * 0.04 = $33k.

    The problem of course is that these factors keep changing which is why some of our insurance is only for 10 years and in five years I’ll look at cutting some of the other insurance depending on our situation at that time.

    Mike

  11. 11. nobleea

    As I understand it, whole/universal life insurance has much higher premiums. Why not take term and invest the difference in a low cost ETF? When the term is over, invest the whole premium amount. This would generate a sizeable portfolio with which to pay taxes.

    But, you should be able to figure out how much money you need for taxes. If you’re passing on the family cottage and want it to stay in the family, then sure, plan for the extra tax amount. But if it’s just money in registered and non-registered accounts, who cares? So they only get 60% of the full amount. That should be more than they were expecting (I would never ‘expect’ an inheritance, nor would I want my children to).

    As for a business, if you want it to stay in the family, that should be part of succession planning, which is far more complicated than just saving some more money.

  12. 12. Cannon_fodder

    FourPillars,

    You included your RRSP’s as part of the income producing base for your wife in the example. Some people may not realise that this will be taxed differently when you withdraw the dividend income from it as opposed to the non-registered assets. It won’t have the same, typically very favourable, treatment that dividends paid out from a portfolio outside an RRSP will.

  13. Cannon_Fodder – very good point. Later on when the rrsp is much bigger (hopefully) and the insurance payout is less then that will be more of a factor then it is right now. Putting the insurance payout (minus debts) into Canadian dividend stocks is not everyone’s cup of tea either since it’s not very diversified.

    I think your point reinforces the need to revisit your insurance needs every once in a while – in five years the rrsp might be twice as much as it is now, or it might be less than it is now. Our expenses might have changed – many many things can change over time.

    My method is more of a rough approximation – in actual fact I used a more complicated procedure but then realized that because of all the future uncertainties – a simpler, more rough estimate is probably just as accurate (if that makes sense).

    Mike

  14. 14. Gates VP

    OK, Evan & Man From Atlantis. I think that you’re crossing some wires here, or maybe just band-aiding the wrong problem.

    Check the Universal Life links to get more details of how this works in Canada. I asked a lot of questions and Ed had a lot of answers, but long story short, when the last person dies and the wealth moves down it all get “cashed out” and any unpaid taxes are due.

    The “family cottage” will incur capital gains taxes, and investments will be converted to cash and losses/gains claimed on taxes. These are all taxes you owed anyways but that were deferred in some way, not some new set of “estate taxes”.

    So, to whit:
    You cause a fire sale of assets that may or may not be worth that amount upon death, i.e. the New York Housing market just took a major hit….if you were to sell your “1,000,000? house it may only go for 800K (housing is down 20% on long island)

    This would be great in Canada, the capital gains would be way lower and the kids would still have the place. (assuming they could cover for the tax)

    Evan brings up two other points:
    FT it is not always simple to sell the assets. Plus business owners spend their life creating something and there is often an emotional attachment to the business – They don’t want to lose it to taxes and they want their kids to take it over.

    You’re not required to sell the assets, you’re just “cashing out”. If you have a home “valued at” 500k when you die, the kids pay your capital gains tax on the difference between the new price and the original and the house is theirs. But you should be able to cover the taxes on an unwanted item by selling that item. If you can’t sell the item then it has no value and can’t incur capital gains taxes.

    As to business owners, that’s a completely different line. Personal life insurance has no relation to Corporate insurance, as nobleea mentions, that’s succession planning and has a scope way wider than some simple “what am insured for”. If people don’t want their businesses taxed to death, they’ve already incorporated and written the legal documents to ensure that succession is handled.

    Really though Evan, what I don’t get is why you’re dying with 4 million dollars in the bank and kids not already taken care of? Is that money fully invested just ready to eaten by the income tax crows? If you have kids that need the money that stuff should already be hidden in trust funds or invested in corporations owned by the offspring or basically off the books. Bill and Melinda Gates aren’t going to pay $80 billion in estate taxes if they died tomorrow, so maybe some minding of business is in order here.

    If you have 4 million and kids and you’re under 30 then maybe none of my ideas are valid. But if you have 4 mil, fully grown kids and you’re over 70 (or some reasonable dying age) then what the heck are you doing with 4 million in assets? By now everything relevant should be in the kids’ names (probably including your home) and you should be living off an annuity.

    I mean maybe you’re somewhere in between (you 55 kids are 30, lots of investments), but if the 1.5 million is even relevant to the next generation, then you’re probably doing something wrong. Like what is that $1M on a home and $3M in stocks and bonds? If you want your kids to have money, why not just say: “Hey Son we’re buying a 500k business jointly and I’m spotting you the money. We’ll draft up the whole thing so that when I die, you get my shares at a deep discount.”

  15. Hi Gates:

    Yeah, we probably are a little off target for the topic. Just a couple points.

    There are some people who will never spend all their money and most often those people have incorporated businesses. This is probably why Evan mentioned the business.

    If they don’t care about how much money they leave to the next generation then sure they don’t need insurance. What I find though, just like insurance needs change over time, people’s attitudes change. As people get older they think more about wanting to leave money to their children or grand children. True not everyone.

    So back to how much insurance do you need. Unless you are going to be very succesful and not spend all your money stick with term and invest the difference. You can always use your home as an insurance policy – it pays out tax free – although you may take the tax free income from the house and spend that too.

    As a side, there is no diffence between corporate and personal life insurance, just the way it is used. Plus it is cheaper to pay for it with corporate dollars.

  16. Gates, you have to keep in mind that in the US they pay estate taxes and are also charged taxes on ‘gifts’ to other people which prevents avoidance of the estate tax.

    I don’t know the exact details but the bottom line is that while the scenario Evan describes doesn’t make a lot of sense in Canada, it does make sense in the US.

    Mike

  17. One way to find an accurate estimate of life insurance to meet your needs is to use an online life insurance needs calculator.

    By answering some questions about your particular financial situation, you get a much more accurate estimate, rather than by using the old 7-10 times your annual income approach life insurance agents used to use.

  18. As has been quoted ad nauseum, the standard metrics are 7 – 15 times annual salary, but paradoxically, be careful not to over-invest in any one policy. Shop around and you’ll be glad you saved the money down the road.

  19. 21. Chris

    Life insurance is not about need…its a want.

    What do you want for your family in terms of income replacement?
    What do you want for your family after suffering the loss of a parent?
    What do you want to leave as a legacy for your children?
    Etc. etc.

    The only relevant question to answer is if you knew you were going to die tomorrow…how much would you buy?

  20. 23. Lookin2Learn

    I’ve heard that a good approximate number for insurance is 10x your annual income. Lets say you make $100k/yr. You took out a $1M policy and you owed
    $400k on your Mtg and other liabilities. When the policy paid out your significant other could pay off the debt and invest the $600k remaining. Assuming a conservative return of 6%/annum. The interest made would be $36,000/yr which the significant other could use to pay bills. It wouldn’t make them rich by any means, but it would definitely reduce their financial burden.

    If I were to pass away I don’t want my family to be put in a situation where they have to sell everything and lower their standard of living because i’m gone. If they decide they want to move or sell some of the assets then that is fine but they shouldn’t have to.

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