Do I Have Enough Life Insurance?Submitted by Affiance Financial on April 12th, 2017
The last few months have been the most exciting of my life. It all started when I found out that my wife, Tyler, and I are expecting. But as the initial excitement subsided, the worrying began. I started wondering: How well does my financial plan work for a family of three? Is my estate plan in order? Do I have enough life insurance?
As I considered my situation, I realized that if I am worrying about these issues, many of our clients must be too. Contemplating one’s own death is not something that many individuals like to do or discuss. That being said, the inevitability of death is very real, and very important to address when considering one’s financial goals.
One of the most important things we can do for our families is make sure we have the right life insurance coverage. And that is true no matter where we are in our financial lifecycle.
The financial lifecycle typically contains three stages. These are:
Your life insurance needs change as you move through the stages.
The accumulation stage is the most important stage in any individual’s financial life. In this stage, wealth is being created. It’s also the stage where, for many individuals, a relatively high-debt and low-savings rate take place. In the accumulation stage, the following life events usually take place:
- Getting married
- Having children
- Buying a home
- Going back to school
- Advancing your career
People in the accumulation stage, generally younger individuals, tend to ignore the risk of premature death as something too remote to even think about. Ironically enough, from a financial-planning standpoint, the younger you are, the more important the management of such risk is. Why? Because if a person dies during the accumulation stage, prior to accumulating sufficient financial assets to meet his or her financial goals, the individual’s family members will be the ones who suffer.
During the accumulation stage, life insurance can be used to hedge against the risk of early death. So if a person dies before accumulating the wealth necessary to satisfy his or her financial goals, such as paying for a home or affording daycare, the death benefit received by the surviving family members will cover the costs.
At the conservation stage, employment earnings have peaked and many families experience an empty nest. It is common for individuals in this stage to have a reduction in debt, as their homes are paid off and their children finish college.
Moving from the accumulation stage to the conservation stage usually entails a reduction in the need for life insurance. Why? Because many financial goals have been taken care of, and no longer threaten to burden survivors.
The main purpose of life insurance at the conservation stage is to provide a surviving spouse with enough supplemental income to sustain their current standard of living, or to ensure a comfortable retirement in the future.
The distribution stage usually occurs when an individual is at or nearing retirement, and begins “spending down” and/or gifting their assets. At this stage of the financial lifecycle, income needs are less of an issue and a person’s financial goals are usually fully funded.
So, moving from the conservation stage to the distribution stage must mean a person no longer needs life insurance, right? Usually not. Why? Because life insurance in the distribution stage can be used to cover funeral costs, administrative costs, and remaining debts. It can also be used to help sustain a family’s wealth.
Life insurance can be a valuable tool for sustaining a family’s wealth by offering significant tax benefits, but only when used properly. Many individuals believe that life insurance is tax free. While the proceeds of the death benefit are always federal income tax free, these proceeds might still be included in the decedent’s gross estate for federal estate tax purposes. This means, the proceeds from your life insurance policy might be added to the value of your property and assets when determining if you owe federal estate taxes. And, if the total value of your gross estate turns out to be greater than $5.45 million, the federal government may claim as much as 40 percent! But, this can be avoided by making the right life insurance ownership policy choices.
For example, if you own a life insurance policy on your own life when you die, the proceeds of the policy are includable in your gross estate. Similarly, if you own a policy and transfer it to another owner within three years of your death, the transfer is not recognized for estate tax purposes, and the proceeds are therefore includable in your gross estate. However, if someone other than you owns the policy, you can avoid subjecting the proceeds to estate tax. The owner of the policy can be another individual or a trust. Irrevocable life insurance trusts are often used for this exact purpose.
Another important factor in determining the tax burden of your life insurance policy is your chosen beneficiaries. If you designate your estate as your policy’s beneficiary, the proceeds are generally includable in your gross estate even if you do not own the policy. Not to mention, naming your estate as beneficiary subjects the proceeds to the expense of probate and claims of creditors. On the other hand, if you name your children as beneficiaries of your life insurance policy, they have the potential to avoid these expenses and receive a greater benefit.
Life insurance is important during every stage of the financial lifecycle, and policies need to be evaluated regularly to ensure they remain suited to your ever-changing financial needs. Major life events, such as the birth of a child, are a great catalyst to re-evaluate your life insurance needs. If you’d like to make sure you are getting the most from your life insurance policies, contact your advisor today.