How to Choose Your Life Insurance: Strategies for Peace of Mind

by Bob Reby, CFP®

How much life insurance do you need?

A common mistake people make in answering this question is to look at the life insurance benefit as a lump sum. It’s actually a lot more practical to consider the income you will need to replace when an income-earning spouse passes away. After all, lifestyle expenses are incurred over time, and we generally pay for those expenses with our income, not out of a lump sum.

We will use $1 million as an example. This may sound like a lot of money and enough to support a surviving spouse. When you think about it as income, however, that million dollars translates to $40,000–$50,000 a year as a predictable lifelong income stream. Is that enough? Maybe, maybe not.

What monthly expenses will the surviving family members have to pay? Are there any major expenses you know you’d like taken care of, such as a child’s wedding or education? Ultimately, it comes down to what you and your spouse need taken care of to have financial peace of mind.

Next, assess the income capability of the surviving spouse. Does he or she have a reliable career and income stream of their own?

Then look at the money being left behind by the deceased in the form of savings, investment accounts, and other assets. How much income can these assets produce? Will these income streams cover the lifestyle expenses and other major financial objectives you feel are necessary for the peace of mind of both spouses? If not, you’ll want to bridge that gap with life insurance.

Keep in mind, if that gap is too wide and the cost of insuring that amount is simply too high, the family should have a discussion about that. Maybe you don’t insure the full amount and instead simply have a plan that you agree on, such as downsizing your house, the car, or some other aspect of your lifestyle that you’re comfortable downsizing. These conversations aren’t as much fun as going to a cocktail party or binge-watching a favorite TV show together, but couples who address these issues find the process rewarding. It eliminates lingering uncertainty that you may not even realize existed until you’ve addressed it.

Choosing the life insurance option that's right for you

Now that you know the size of the death benefit you’d like to leave behind, it’s time to decide what type of life insurance to buy.

Keep in mind, while life insurance is primarily considered a death benefit, it has many other uses that most people are not aware of—particularly when it comes to estate planning and leaving a legacy in a tax-efficient manner. However, the focus of this article is on replacing income for dependents if you die prematurely.

There are many different kinds of life insurance, each with its own unique set of benefits. The two I’ll compare here are term life insurance versus whole life insurance (a type of “cash value” insurance).

Let’s say that Bill M., a successful manager at a major Fortune 500 corporation, is getting married. Suddenly, Bill M., who never even thought about buying life insurance, now has a new bride to protect. He takes out a term life insurance policy with a death benefit equal to ten times his annual $100,000 salary. That $1 million death benefit will help his grieving widow, who does not currently work outside the home, to regain her financial footing and eventually move on with her life.

As Bill M. and his new bride move through their lives, they welcome a new addition to their family. Suddenly Bill M. is a proud papa as well as a loving husband, and he has even more to protect. By the time his five-year term life policy expires, he has a toddler in the house and needs a more substantial death benefit.

Bill M. is now making $150,000 a year and he wants to up his death benefit to twenty times that amount. That means a $3 million term life insurance policy, and since Bill M. is now five years older, the premium price tag has risen substantially. Bill M. begins to shop around, looking not only at other term life policies but other types of insurance as well.

If Bill M. decides to purchase a whole life policy, he can combine the death benefit that protects his wife and child with an investment component that helps his family save for the future. In sixteen years, when his two-year-old toddler is looking at colleges, Bill M. can borrow against the cash value of his whole life policy to offset the cost of tuition and supplement college loans, grants, and other ways to pay for college. If his child gets a scholarship and the money is not needed for tuition, the value of the policy may be used for retirement income or any other lifestyle goals Bill M. and his family may have.

Term life insurance would be less expensive than whole life, but it has no savings component. Once the term ends, it’s over and you don’t get anything back. The downside of whole life insurance is that it’s more expensive, and you run the risk of earning a smaller rate of return on the investment component of the insurance than you would have earned had you invested the money elsewhere.

Your final decision may come down to a few factors:

• Your tax situation, as there are many creative ways to use whole life insurance for estate planning, education planning, and other goals in a tax-efficient manner.
• Your risk profile as an investor; if you’re of the mindset that you’re willing to accept more risk in exchange for higher expected returns, you’re probably better off with a term life insurance and investing the savings.
• The level of certainty vs. flexibility you want, as the more expensive whole life insurance gives you a more certain payout, while lower cost term insurance gives you more flexibility.

Because there is not one definitive right answer to what type and how much life insurance do you need, this is a topic that I’d strongly recommend discussing with a Certified Financial Planner.™

This blog was was an excerpt from Chapter 5 of Bob Reby's new book Wealth Redefined: Charting the Way to Personal and Financial Freedom. The chapter is titled "Protecting Your Income from Catastrophic Risks," inspired by the income protection category on the firm's Lifestyle Sustainability Scorecard™​. 

To buy the book with free shipping or download a complimentary chapter, go to www.wealthredefined.com.