Saving You Money For Life

There are several reasons why people buy term life insurance.  The primary reason–to replace the loss of a breadwinner’s income.  Another reason is that life insurance is the least expensive way to offset estate tax liabilities.  While there are countless other uses for life insurance, this article will address ways to calculate the amount of life insurance you should own to solve each of these two problems.

First, what factors should be used in determining the need for replacement income?

This question is best answered using an example.  For instance, assume the following:  (1) the proposed insured earns $75,000 annually, (2) he wants to make sure his family can maintain their standard of living for the next 20 years and feels that his family can do this using 80% of his current income ($60,000 annually), (3) he figures that his spouse will invest the insurance death benefit proceeds at approximately 7% interest, and (5) that inflation will average 4% per year.

Assuming all of the above, according to a simple mathematical model, it will require a lump sum death benefit (from life insurance) of $1,228,198 to provide his family with an annual indexed income of $60,000 for 30 years!  In the first year, $60,000 of income is taken from the $1,228,198.  The remaining $1,168,197 is invested and would earn $81,774 (7% interest).  The total amount is reinvested, and $62,400 of income is taken for the second year.  The remainder is once again invested, and so on for 30 years.

Why do we use the inflation factor to index the income?   Because the $62,400 in the second year has the exact same purchasing power as the $60,000 in the first year, assuming 4% inflation.  Each year of income must be indexed in this manner to keep pace with inflation.  Of course, the earnings of 7% are added to the remaining principal balance each year.

But, in 30 years, you can see (in the chart below) that there is just enough money left for the final year of income.  The original $1,228,198 will have been completely used up producing the indexed income, and nothing is left.

The numbers will vary in each case, but, of course, the numbers don’t lie.  If you have access to the Internet, you can access a very handy and easy to use (and free) life insurance needs calculator which will allow you to tinker with variations on the income, interest, and inflation factors.  By using it yourself and plugging in your own numbers, you can become more comfortable with the amount of life insurance you own, or you can make the appropriate adjustments.

To calculate the amount of life insurance needed to offset your inevitable estate tax bill, you need to determine what your total net worth will be when you die.  This, of course, is easier said than done.  If your estate plan includes a properly funded A/B trust (ask your lawyer), then you can avoid taxes on the first $1,200,000.  And, most people delay payment of these taxes until the second death, using the unlimited marital deduction.  But then, watch out!   Every dollar over $1,200,000 is taxed at a minimum rate of 37%, rising to 55% on estates over $3,000,000!  Worse (or better) yet, your estate, and the size of the problem is, most likely, still growing.

If you’re considering whether it makes sense to use life insurance policies as a method of liquidating and discounting your inevitable estate tax liability, consider that if you’re healthy, it can generally be done for just pennies on the dollar!

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