Posted on

How to Buy Life Insurance

How to buy life insurance

Choosing the right type of life insurance policy and its death benefit can be confusing. Not too long ago, I published a guest post from Baruch Silverman of The Smart Investor on the different types of life insurance. In this post, you’ll learn how to buy life insurance.  Specifically, I’ll help you evaluate which, if any, of those types of policies fit your situation and how to select your death benefit.

Why are You Buying It?

The first thing you want to consider is why you are buying life insurance. Three common purposes are:

  • the death benefit.
  • the investment returns.
  • sheltering gifts to your heirs from income taxes.

Death Benefit

If your primary purpose for purchasing life insurance is the death benefit, you’ll want to focus on term and whole life insurance.

Investment Portfolio

Some people use life insurance similar to other financial securities (such as stocks and bonds). Variable life and universal life have investment components to them. In simplified terms, the total amount you pay as premium for these types of life insurance is split between the amount to cover the cost of a whole life policy and the excess which can be invested. As such, the life insurer doesn’t invest the portion of premium related to the death benefit.  Further, the life insurer reduces the excess to cover its expenses, a risk charge and its profit margin before investing it.

Variable and universal life policies include the cost of whole life insurance.  Thus, only people who want the coverage provided by whole life insurance might consider using life insurance as part of their investment portfolio. Even then, the returns may not be as high as other investment vehicles with similar risk because of the additional costs charged by the life insurer.

Tax Shelter

Sheltering gifts to your heirs from income taxes only applies to the very wealthy (those who have more than $11 million in assets). I’m assuming that the vast majority of my readers aren’t in this situation, so won’t address it here.

Other Considerations

All types of life insurance can have an indirect impact on your investment portfolio. If you purchase life insurance in an amount that will cover your dependents’ basic living expenses, it allows you the option to invest your portfolio in riskier assets in anticipation of getting higher returns. That is, the death benefit itself could be considered a low-risk investment.  It reduces your overall portfolio risk when added to the other assets you own.

Do I Need Life Insurance?

Some people don’t need the death benefit from life insurance. In that case, it doesn’t make sense to buy life insurance as an investment security either. In the last section of this post, I provide the details of estimating your target death benefit. People whose target death benefit is zero are those who don’t need life insurance.   Briefly, characteristics of people who have a target death benefit of zero are:

  • Their available assets are more than their debts. Available assets exclude any illiquid assets (such as any real estate or personal property they own), savings for their dependents’ retirement (but not their retirement as they don’t need retirement savings after you die), emergency savings and any savings designated for large purchases.
  • They have enough money to cover their dependents’ education expenses.
  • Their dependents can support themselves on their existing income plus your available assets, including being able to make debt payments as they are due or after using available assets to pay off any debts.
  • They have enough money to pay any end-of-life expenses related to their death.

If you aren’t sure if you meet these criteria, keep reading!

Term vs. Whole

If  you’ve decided that you are buying life insurance for the death benefit, you need to decide whether term life or whole life insurance will better meet your needs. The primary differences between the two options are the length of time you need the insurance and the cost.

Term Life

If you think you will need life insurance for a limited period of time, term life insurance is likely better for you. For example, you might have dependents who aren’t currently able to cover their living expenses and the cost of any debt.  In that case, you might want to buy life insurance that will pay off your debts and support your dependents until they are independent.  If your needs change, many insurers will let you convert a term life insurance policy to a whole life policy without having to provide medical information or have a physical, one or both of which are often pre-requisites for purchasing whole life insurance.

Term life premiums are constant over the term of any policy you purchase. However, if you buy a policy when you are older, the premium will be higher than if you buy the same policy when you are younger.

Whole Life

If you think you will need life insurance for your entire life, whole life insurance is likely better for you. For example, if you have a spouse or disabled children who will never be able to support themselves, whole life insurance could supplement your savings to help make sure they are able to live more comfortably, regardless of when you die.

In addition to the death benefit, whole life insurance gives you the option to borrow money. As you pay premium, life insurers designate a portion of your premium as the cash value. The cash value is always owned by the insurance company, but you are able to borrow an amount up to the cash value at any time without prior approval, any collateral or impact on your credit score. The interest rates on cash-value loans are less than many other sources, particularly credit cards. If you die before the loan is re-paid, the amount of the loan will be deducted from your death benefit.

Cost Comparison

Whole life insurance is much more expensive than term life when you are young, but eventually becomes less expensive.

Probability of Dying

The graph below provides some initial insights into the difference in cost between whole life and term life, as it shows the probability that you will die at each age. I calculated the values based on 2016 data from the Social Security web site.

Not surprisingly, the probability you will die increases at each age. If you buy whole life insurance, it will cover the entire portion of the graph from your current age until you die. As such, there is a 100% probability that the life insurer will pay your death benefit (assuming you continue to pay your premiums). It is just a question of when.

If you buy a 20-year term policy and you are 30 years old, only the deaths that occur in the portion of the graph below highlighted in green would be covered. That is, you will receive the death benefit if you die between ages 30 and 50 and will get nothing if you die after age 50.

The probability you will die is much smaller in this narrow window than the 100% probability you will die at some point.

Present Value of the Death Benefit

There are many factors that determine the premium for term life and whole life insurance policies, but the most important component relates to the death benefit. Actuaries (who help price life insurance) usually base the portion of premium related to the death benefit as the present value of the death benefit expected to be paid, on average, in each year.

One-Year Term Policy

The chart below shows the present value for $1 of death benefit for several sample policies. For illustration only, I have calculated the present values using a 3% interest rate and the probabilities of dying from the charts above.

The easiest way to see the impact of the increasing probability of dying is to look at the present value of the death benefit for a 1-Year Term Life policy. You can see it increases from almost zero (actually $0.0015 per dollar of death benefit) at age 25 to $0.042 per dollar of death benefit at age 70 which corresponds exactly to the increase in the probability of dying at each age.

Policies with Longer Terms

There are also increases in the present value of the death benefit for the Whole Life and 20-Year Term Life policies as the age you first start buying the policy increases.

You can also see that the present value of the death benefit at age 25 for the Whole Life policy is much, much larger than the present value for either of the two term life policies. This relationship corresponds to the graphs above which compared the probability of dying in a 20-year period as compared to the 100% probability that you will die at some point.

The difference between the Whole Life and 20-Year Term Life policies is fairly small at age 70, because there is a high probability that you will die between age 70 and 90 – the period covered by the 20-Year Term Life policy. In fact, almost 80% of people age 70 will die during the 20-Year Term Life policy period.  As such, the present value of the death benefit for a 20-Year Term Life policy at age 70 is very roughly 80% of the present value of the death benefit for a Whole Life policy.

Annual Premium

The insurance company collects premium over the full life of the insurance policy to cover the present value of the death benefit. That is, you don’t pay all of your premium to the insurance company in one lump sum, but rather on an annual or monthly basis.

Unless you die during the policy term of the Term Life policy, you will pay premium for more years under a Whole Life policy than under a Term Life policy. Therefore, the differences you see above are larger than the differences in premium payments.

Illustration

The chart below shows the annualized amount of the loss costs. That is, I divided the present values of the death benefits by the average number of years an insured is expected to pay their premium. For example, for the 20-Year Term Life policy, the denominator was calculated as the sum of the probabilities that the insured would be alive in each of the 20 years and therefore able to pay his or her premium.

Post 49 Estimated Premium

Although these relationships are not precise, they are roughly representative of the differences in annual premium you might pay for the different types of policies at different ages. At age 25, the annual cost of a Whole Life policy in this illustration is roughly three times the cost of either of the Term Life policies. By age 70, the annual cost of a Whole Life policy is less than the cost of 20-Year Term Life policy because, while the present value of the death benefit isn’t all that different between the two policies, people who buy Whole Life policies make more premium payments, on average.

Reality vs. Illustration

It is important to understand that I prepared these examples as illustrations to help you understand the differences between Whole Life and Term Life insurance premiums. In practice, life insurers use different tables showing the probability of dying and different interest rates than I used for illustration, as well as using more sophisticated methods for calculating the present value of the death benefit and including provisions for expenses, risk and profit.

In practice, I’ve seen estimates that Whole Life annual premiums are anywhere from three to fifteen times more than Term Life premium at young ages. As you are looking at your options, you’ll want to get several premium quotes, as they vary widely depending on your age, location, gender, health and many other factors.

How Much to Buy

As with any financial decision, there are two conflicting factors that will influence the amount of the death benefit you buy on a life insurance policy – your budget and your financial needs. In the section, I will talk about how to estimate the best (i.e., target) death benefit for your situation. Once you’ve selected an amount, you can get quotes from several insurers to see whether the premium for that death benefit will fit in your budget or whether you will need to find the best balance between premium affordability and death benefit for you.

Rules of Thumb

Not surprisingly, there are some rules of thumb for guiding your selection of a death benefit. Some of the ones I’ve heard are:

  • Three to five times your salary
  • Ten times your total earned income (i.e., salary, value of benefits and bonus)
  • Ten times your total earned income plus $100,000 per child for college

Rules of thumb like these can provide some insights, but they, by definition, can’t take into account your personal circumstances.

Tailored Approach

A better approach for selecting a death benefit is to analyze your own finances and goals for buying life insurance.   I suggest calculating your target death benefit as the total of the amounts needed to meet your goals, considering the following components.

Debt

If you have debt, you’ll want to consider whether your dependents will be able to continue to make the payments on the debt out of their own income. For example, if your spouse’s earned income is high enough to continue to make your mortgage payments, along with all of the other expenses he or she will need to cover if you die, then you might not need to include the remaining principal on your mortgage as a component of your target death benefit. On the other hand, if you are concerned about your dependents’ ability to continue payments on any debt, you’ll want to include the outstanding principal on those debts as a component of your target death benefit. I’ll define this amount as “Debt Principal to be Pre-Paid.”

Final Expenses

When you die, your dependents will incur some one-time expenses. These expenses can include your funeral or memorial costs and professional expenses to settle your estate. I’ll call the amount of these expenses, “Final Expenses.”

Net Future Living Expenses

The next component of your target death benefit calculation is the amount you need to cover your dependents’ future living expenses.

Current Expenses

Start with your household’s total expenses from your budget. This amount will include monthly expenses for everyone in your household, the amounts you are setting aside each month for your designated savings and any amounts you are setting aside for your spouse’s retirement. To be clear, it will exclude any amounts you are saving for your own retirement.

You can eliminate any monthly expenses or amounts for designated savings for things that are only for your benefit. For example, if you spend enough money on clothes for your job to include it in your budget, you can eliminate those expenses. Similarly, you can also eliminate any expenses related to a vehicle that only you drive or designated savings to replace it.

Earned Income

You then need to calculate your dependents’ monthly earned income. This amount may be calculated in two parts – current monthly earned income and future monthly earned income. For example, your spouse may currently work part time as you are relying primarily on your income for support. If you die, your spouse may be able to work full time to increase his or her earned income. Alternately, your spouse may need some education (discussed below) to get the qualifications needed for his or her desired profession.

Extra Expenses

Next, you’ll need to calculate the amount of any expenses that your household will have because of any changes in your spouse’s availability to provide household services. For example, your spouse may work part-time while your children are in school and provide childcare after school. If your spouse starts working full time after your death, you will need to add after-school care expenses to your budget.

Time Periods

The last factor that goes into this calculation is the length of time until you think your dependents will become self-sufficient. For children, you might assume that they will become independent after they turn 18 or graduate from college. The ability of your spouse to become self-sufficient will be a function of his or her skills, education and/or need for more education and household responsibilities (e.g., childcare or elder care).

I suggest splitting the calculation of this component of your death benefit into three time periods – short-term, medium-term and long-term. For each time period, you’ll calculate your net living expenses as expenses minus income. For any periods for which income is more than expenses, set the difference to zero.

  1. Short term – During this time period, you’ll use your current monthly expenses, excluding your personal expenses, and your dependents’ current monthly earned income.
  2. Medium term – During this time period, you’ll use your current monthly expenses with adjustments for extra expenses for services currently provided by your spouse and your dependents’ future monthly earned income.
  3. Long term – During this time period, you’ll assume that your children (other than those who will always be dependent on you for care) are self-sufficient, so can eliminate all expenses related to children and their care from your expenses. You’ll use your spouse’s future monthly earned income. In many households, income in this period will exceed expenses so there may not be a need for death benefits to cover expenses in this period.

You also need to estimate how many months each of these three time periods will last.

Net Future Living Expenses

Your Net Future Living Expense amount for each time period is calculated as the number of months it will last multiplied by monthly net living expense amount. You can then calculate your total Net Future Living Expenses as the sum of the three amounts you calculated for the three time periods.

For those of you who like to see formulas instead of words, you will calculate:

  1. Short-term Net Expenses = Greater of 0 and Current Expenses – Current Income
  2. Medium-term Net Expenses = Greater of 0 and Current Expenses + Extra Expenses – Future Income
  3. Long-term Net Expenses = Greater of 0 and Future Expenses – Future Income
  4. Net Future Living Expenses = (number of months in short-term period x Short-term Net Expenses) + (number of months in medium-term period x Medium-term Net Expenses) + (number of months in long-term period x Long-term Net Expenses)

You could refine this amount by considering inflation and investment returns. Depending on your investment strategy and the time until the funds are used, your investment returns, on average, can be more than inflation. As a conservative first approximation, I suggest using the total without adjustment for inflation and investment returns.

Education

There are two types of education expenses that you might want to include in your target death benefit calculation:

  1. The portion of the cost of education for your children that you want to provide. Some people suggest $100,000 per child for college. This amount may or may not be the right amount depending on how much you expect your children to contribute to their educations, how many years of college education you want to support and what type of school they attend. Prestigious colleges can cost as much as $75,000 to $80,000 a year currently (2020), while in-state tuition (assuming your children live at home while attending college) can cost as little as $15,000 a year in some states. Other children may not go to college or may attend a trade school.
  2. The cost of any education your spouse needs or wants to allow him or her to work in a profession he or she enjoys and allows him or her to earn enough money to increase his or her independence.

Target Death Benefit Calculation

You can now calculate your target death benefit as follows:

Debt Principal to be Pre-Paid

Plus        Final Expenses

Plus        Net Future Living Expenses

Minus   Savings in excess of your real estate and personal property assets, emergency fund, designated savings and spouse’s retirement savings

Plus        Education Expenses

Minus   Amounts in existing college funds

Minus   Any amounts included in your Net Future Living Expenses designated for college

If you are single with no debt, this amount could be zero indicating that you might not need to buy life insurance. If you are married with no children, don’t have a lot of debt and have a spouse who can increase income or decrease expenses to be self-sufficient fairly quickly, you may need only a small death benefit. At the other extreme, if you have several children and a spouse who won’t be able to be financially independent for many years or ever, your target death benefit could exceed $1 million.   As you can see, the specifics of your financial situation are very important to setting a target death benefit and a rule of thumb may not work for you.

Posted on

A Man is Not a (Sound Financial) Plan

A man is not a plan

“A Man is Not a Plan!” It sounds like a very dated statement, but a guide on a recent trip I took told me about a conversation he had with one of his nieces about her finances.  They were talking about how she could improve her financial situation by building a sound financial plan. As they were talking, one of them came up with the slogan, “A Man is Not a Plan.” He suggested I use it as the title for one of my posts. So, here it is!

In this post, I will talk about the key components of a sound financial plan. A financial plan provides the structure to help you organize your financial information and decisions. I’ll provide brief explanations of the things to consider about each component, what you need to do and, for most of them, links to posts I’ve written that provide much more detail. I’ll also provide insights on how to know when you need help and who to contact.

Sound Financial Plan

A sound financial plan includes the following sections:

    • A list of your financial goals – In this section, you’ll want to identify your three to five most important financial goals.
    • A list of your current assets and liabilities (debts)
    • Your budget
    • Your savings and investment strategies to help you attain your goals, including
      • Short-term savings
      • Designated savings
      • Retirement savings
    • Desired use of debt, including re-payment of current debt
    • Risk management strategy, i.e., types and amounts of insurance to buy
    • Understanding of your income tax situation
    • What you want to have happen to you and your assets when you become incapacitated or die and related documents

     

  • You will likely be most successful if you create a formal document with all of these components of a sound financial plan. You’ll want to review and update your financial plan at least every few years, but certainly any time you have a significant change in your finances (e.g., a significant change in wages) or are considering a significant financial decision (e.g., buying a house, getting married or having children). Of course, a less formal format is much better than no plan at all, so you should tailor your efforts to what will best help you attain your financial goals.

    Budget

    A budget itemizes all of your sources of income and all of your expenses, including money you set aside for different types of savings. It provides the framework for all of your financial decisions. Do you need to change the balance between income and expenses to meet your goals? Can you make a big expenditure? How and what types of insurance can you afford? How much debt can you afford to re-pay?

    I think that a budget is the most important component of a sound financial plan and should be the first step you take. Everyone should have a good understanding of the amounts of their income and expenses to inform the rest of their financial decisions.  While some people will benefit from going through the full process of creating a budget and monitoring it, others can be a bit less detailed.

    In the text section of your financial plan, you’ll want to include a list of your financial goals as they relate to your budget and how you plan to implement them. You can include your actual budget in your financial plan itself or as a separate attachment.

    Savings

    I generally think of savings in three categories (four if you include setting aside money for your kids): emergency savings, designated savings and retirement savings. You will want to address each of these types of savings in your financial plan. The information you’ll want to include for each type of savings is:

    • How much you currently have saved.
    • The target amounts you’d like to have saved.
    • Your plan for meeting your targets.
    • For what you’ll use it.
    • How fast you’ll replenish it if you use it.
    • How much you need to include in your budget to meet your targets.
    • Your investing strategy.
    • A list of all financial accounts with location of securely stored access information.

    Emergency Savings

    Emergency savings is money you set aside for unexpected events. These events can include increased expenses such as the need to travel to visit an ailing relative or attend a funeral or a major repair to your residence. They also include unexpected decreases in income, such as the reduced hours, leaves of absence or lay-offs related to the coronavirus.

    The general rule of thumb is that a target amount for emergency savings is three to six months of expenses. I suggest keeping one month of expenses readily available in a checking or savings account that you can access immediately and the rest is an account you can access in a day or two, such as a money market account.

    Designated Savings

    Designated savings is money you set aside for planned large expenses or bills you don’t pay every month. Examples might include your car insurance if you pay it annually or semi-annually or money you save for a replacement for your car you are going to buy in a few years.

    To estimate how much you need to set aside for your designated savings each month, you’ll want to look at all costs that you don’t pay every month and figure out how often you pay them. You’ll want to set aside enough money each month to cover those bills when they come due. For example, if your car insurance bill is $1,200 every six months, you’ll want to put $200 in your designated savings in each month in which your insurance bill isn’t paid. You’ll then take $1,000 our of your designated savings and add $200 in each month it is due to pay the bill.

    Retirement Savings

    Saving for retirement is one of the largest expenses you’ll have during your working lifetime. There are many aspects of saving for retirement:

    • Understanding how much you will receive in retirement from government programs, such as Social Security in the US or the Canadian Pension Plan in Canada.
    • Setting your retirement savings goal.
    • Estimating how much you need to save each year to meet your retirement savings goal.
    • Deciding what are the best types of accounts in which to put your retirement savings – taxable, Roth (TFSA in Canada) or Traditional (RRSP in Canada).
    • Determining in what assets (bonds, stocks, mutual funds or ETFs, for example) to invest your retirement savings in light of your risk tolerance and diversification needs and how those choices affect your investment returns.

    Debt

    Debt can be used for any number of purchases, ranging from smaller items bought on credit cards to large items purchased with a loan, such as a home. Whether you have debt outstanding today, use credit cards regularly and/or are thinking of making a large purchase using debt, you’ll want to define your goals with respect to the use of debt.

    For example, do you want to never have any debt outstanding (i.e., never buy anything for which you can’t pay cash and pay your credit card bills in full every month)? Are you willing to take out a mortgage as long as you understand the terms and can afford the payments? Do you have a combination of a high enough income and small enough savings that you are willing to use debt to make large purchases other than your home? Do you have debts you want to pay off in a certain period of time?

    As you think about these questions, you’ll want to consider what debt is good for you and what debt might be problematic.  A sound financial plan includes a list of your debts, how much you owe for each one, your target for repaying them, and your strategy for using debt in the future.

    Credit Cards

    Credit cards are the most common form of debt. Your financial plan might include the number of credit cards you want to have and your goals for paying your credit card bills. As part of these goals, you might need to add a goal about spending, such as not buying anything you can’t afford to pay off in a certain period of time.

    Student Loans

    Many people have student loans with outstanding balances. In your financial plan, you’ll want to include your goal for paying off any student loans you have. Do you want to pay them off according to the original schedule? Are you behind on payments and have a goal for getting caught up? Do you want to pay off your student loans early?

    Car Loans

    In a perfect world, your car would last long enough that you could buy its replacement out of your designated savings. However, the world isn’t perfect and you may need to consider whether to take out a loan or lease a car. Your financial plan will include your strategy for ensuring that you always have a vehicle to drive. How often do you want to replace your car? What is your goal with respect to saving for the car, loans or leases? How much will it cost to maintain and repair your car?   Your budget will include the amounts needed to cover the up-front portion of the cost of a replacement car, any loan or lease payments and amounts to put in designated savings for maintenance and repairs.

    Mortgages

    Most homeowners borrow money to help pay for it As part of creating your financial plan, you might include your goal for home ownership. Are you happy as a renter for the foreseeable future or would you like to buy a house?

    If you want to buy a house either for the first time or a replacement for one you own, you then need to figure out how to pay for the house. How much can you save for a down payment? Can you set aside enough in designated savings each month to reach that goal? What is the price of a house that you can afford, after considering property taxes, insurance, repairs and maintenance?

    Once you have a mortgage, you’ll want to select a goal for paying it off. When a mortgage has a low enough interest rate, you might make the payments according to the loan agreement and no more. If it has a higher interest rate or you foresee that your ability to make mortgage payments might change before it is fully re-paid, you might want to make extra payments if you have money in your budget.

    Paying Off Debt

    If you have debt, you’ll want to include your goals and your strategy for paying it off in your financial plan. You’ll first want to figure out how much you can afford each month to use for paying off your debts. You can then compare that amount with the amount needed to meet your goals. If the former is less than the latter, you’ll need to either generate more income, reduce other expenses, put less money in savings or be willing to live with less aggressive goals. These decisions are challenging ones and are a combination of cost/benefit analyses and personal preference.

    Insurance

    Protecting your assets through insurance is an important part of a sound financial plan. The most common types of insurance for individuals cover your vehicles, residence, personal liability, health and life. There are other types of insurance, such as disability, dental, vision, and accidental death & dismemberment, that are most often purchased through your employer but can also be purchased individually.

    As I told my kids, my recommendation is that you buy the highest limits on your insurance that you can afford and don’t buy insurance for things you can afford to lose. For example, if you can afford to pay up to $5,000 every time your home is damaged, you might select a $5,000 deductible on your homeowners policy. Alternately, if you can afford to replace your car if it is destroyed in an accident, you might not buy collision coverage at all. Otherwise, you might set lower deductibles as your goal.

    For each asset in your financial plan, including your life and health which can be considered future sources of income or services, you’ll want to select a strategy for managing the risks of damage to those assets or of liability as a result of having those assets.

    A financial plan includes a list of the types of policies you purchase, the specifics of the coverage provided and insurer, changes you’d like to make to your coverage and your strategy for insurance in the future. You’ll also want to attach copies of either just the declaration pages or your entire policies to your financial plan.

    Car Insurance

    Car insurance can provide coverage for damage to your car, to other vehicles involved in an accident you cause and injuries to anyone involved in an accident. The types of coverages available depend on the jurisdiction in which you live, as some jurisdictions rely on no-fault for determining who has to pay while others rely solely on tort liability.

    Homeowners Insurance

    Homeowners insurance (including renters or condo-owners insurance) provides coverage for damage to your residence (if you own it), damage to your belongings and many injuries to people visiting your residence.

    Umbrella Insurance

    One way to increase the limits of liability on your car and homeowners insurance is an umbrella insurance policy. An umbrella also provides protection against several other sources of personal liability. If you have money in your budget for additional insurance, you might consider purchasing an umbrella policy.

    Health Insurance

    Health insurance is likely to be one of your most expensive purchases, unless your employer pays a significant portion of the cost. Whether you are buying in the open market or through your employer, you are likely to have choices of health insurance plan. Selecting the health insurance plan that best meets your budget and goals can be challenging.

    Life Insurance

    There are many types of life insurance, including term and whole life. Some variations of whole life insurance provide you with options for investing in addition to the death benefit. Once you have compiled the other components of your financial plan, you’ll be better able to assess your need for life insurance. If you have no dependents and no debt, you might not need any. At the other extreme, if you have a lot of debt and one or more dependents, you might want to buy as much coverage as you can afford to ease their financial burden if you die. To learn more specifics about buying life insurance, you might review this post.

    Income Taxes

    Some of your financial decisions will depend on your income tax situation.

    • Do you want your investments to produce a lot of cash income which can increase your current income taxes or focus on appreciation which will usually defer your taxes until a later date?
    • Is a Roth (TFSA) or Traditional (RRSP) plan a better choice for your retirement savings?
    • Are you having too little or too much income taxes withheld from your paycheck?
    • Do you need to pay estimated income taxes?
    • How will buying a house, getting married or having children affect your income taxes?
    • Will moving to another state increase or reduce your income taxes?

     

  • As you consider these and other questions, you’ll want to outline at least a basic understanding of how Federal and local income taxes impact your different sources of income as part of creating a sound financial plan.

    Legal Documents

    Although it is hard to imagine when you are young, at some point in your life you may become incapacitated and will eventually die. There are a number of documents that you can use to ensure that your medical care and assets are managed according to your wishes. You can either include these documents as part of your financial plan or create a list of the documents, the date of the most recent version of each one and where they are located.

    Powers of Attorney

    There are two important types of powers of attorney – medical and financial.

  • A medical power of attorney appoints someone to be responsible for making your medical decisions if you are physically or mentally incapable of doing so. You can supplement a medical power of attorney with a medical directive that is presented to medical personnel before major surgery or by the person appointed to make medical decisions that dictates specifically what is to happen in certain situations.A financial power of attorney appoints someone to be responsible for your finances if you are physically or mentally incapacitated. The financial power of attorney can allow that person to do only a limited number of things, such as pay your bills, or can allow that person to do anything related to your finances.

    Trusts

    There are several forms of trusts that can be used to hold some or all of your assets to make the transition to your beneficiaries easier when you die. Trusts can also be used to hold money for your children either before or after you die. While I am familiar with some types of trusts, I don’t know enough to provide any guidance about them. If you are interested in them, I suggest you research them on line and/or contact a lawyer with expertise in trusts.

    Your Will

    If you die without a will, your state or provincial government will decide how your assets will be divided. In many jurisdictions, your spouse, if you have one, will get some or all of your assets. Your children or parents may also get some of your assets. Most people want more control over the disposition of their assets than is provided by the government.

  • A will is the legal document that allows you to make those specifications. Your will can also identify who will become legally responsible for your minor children or any adult children who are unable to take care of themselves. That responsibility can be split between responsibility for raising your children and responsibility for overseeing any money you leave either to their guardian(s) or for them.

    How to Know When You Need Help

    As you can see, there are a lot of components to a sound financial plan and many of them are interrelated. There are many resources available to help you develop and refine your plan. Many of those resources are free, such as the links to the articles I’ve published on relevant topics. There are also many other sources of information, including personal stories, on line.

    You can also get more personalized assistance. There are many types of financial advisors, a topic I’ll cover in a post soon. Many financial advisors provide a broad array of services, while others specialize in one or two aspects of your financial plan.

    Sources of Advice

    The table below lists the types of obstacles you might be facing and the types of advisors that might be able to help.

    Obstacle Possible Advisors
    I can’t figure out how to make a budget or how to set aside money for emergency or designated savings. Bookkeeper, accountant, financial planner
    I can’t make my budget balance. Bookkeeper, accountant, financial planner
    I have more debt that I can re-pay. Financial planner, debt counselor, debt consolidator
    I don’t know what insurance I should buy. Financial planner, insurance agent or, for employer-sponsored health insurance, your employer’s human resource department
    I’m not sure I’m saving enough for retirement. Financial planner
    I have questions about how to invest my savings, including whether I am diversified or need to re-balance my portfolio. Financial planner or stock broker
    I don’t understand how income taxes work. Accountant
    I need help with a Trust, Power of Attorney or Will. Wills & estates lawyer

    Clearly, a financial planner can help with many of these questions, but sometimes you’ll need an advisor with more in depth expertise on one aspect of your financial plan.

Posted on

The Different Types of Life Insurance

The life insurance landscape is confusing, to put it lightly. One can get lost in the different types of policies and terminologies, such as whole life, term life, cash value, variable life, and a lot more. If you want to purchase life insurance, you need to first understand the different types, how they work, their cost and which type is right for you and your lifestyle. They fall under four basic types: term, whole, universal and variable.

But how do you make sense of all the different types to ensure that you are picking the correct and best one? Here’s a quick breakdown of the four most common types of insurance policies.

Types of Life Insurance

There are two time-frames over which you can buy life insurance – a stated term or the rest of your life. Insurance that provides benefits over a stated term is known as term life. Permanent life policies provide benefits for the rest of your life (as long as you continue to make premium payments). There are three common types of permanent life insurance – whole life, universal life and variable life.

Term Life Insurance

Term life protects the insured for a pre-determined number of years which is usually any period from 10, 15, 20 or 30 years. The length of time the insurance is in effect is the “term” of the policy. When the term ends, the policy can be renewed on an annual basis as long as the premium is paid. Most insurance companies allow the policy owner to renew until the age of 95, after which point the probability of dying is so high as to make the cost of the insurance almost the same as the death benefit. The life insurance offered by employers is usually term life with a term of one year.

Term life is the most popular type of life insurance and the most affordable. Many financial advisors recommend that you buy term life insurance instead of whole life insurance and use the money you save to invest. But remember that this is a piece of general advice and not specific because you should first consider your own needs and personal situation. What product is most appropriate for you will depend on many things.

Here are the main strengths of term life insurance.

Flexibility

Life insurance will provide cash for your beneficiary so your family can deal with the negative financial consequences of your death. Term life insurance policies are very flexible in that they easily adjust to the policyholder’s needs.

Death Benefit

Beneficiaries do not pay income taxes on death benefits from life insurance. If the policy is properly owned, the death benefits can also be free from estate taxes.

Whole Life Insurance

When you buy traditional whole life insurance, the death benefit and the premium stay the same throughout the term of the policy. As indicated in the name, the term of a whole life is your entire life or until you stop paying the premium.

As you get older, the probability that the death benefit will be paid increases leading to increases in the amount of premium needed to pay for the death benefit (as would be seen in the premium increases you would pay if you bought a series of one-year term life insurance policies). You can imagine that the cost gets very high if you live to 80 years old or more. The insurance company could just assign a premium for term life insurance that goes up each year but it will come to a point that it will be very expensive for people at advanced ages.

Under a whole life policy, the insurance companies keep the premium level by charging a premium that is higher in the early years. This premium is more than what they need to pay claims when you are younger so they invest the money and use it to help pay the cost of insurance as you get older while keeping the premium level.

The main advantages of whole life insurance are as follows.

Lifetime Guaranteed Insurance

With whole life, the insurance company guarantees a premium amount that you have to pay. This means that this amount will stay the same for the rest of your life and will not increase. You can also rest assured that your loved ones/beneficiaries will receive a guaranteed, lump-sum payment at the time of your demise. You may also choose your business to be a beneficiary if you want.

Cash Value Accumulation

Aside from having life insurance for life, whole life also allows you to build a significant cash asset, as the insurance company sets aside a portion of the premium in an account. What’s more, your cash asset under a whole life policy is not going to be dependent on the ups and downs of the market at any time. You can also borrow against the cash value portion of your whole life policy. So, in case you need money for other things in the future such as payment for a home, college funding or a business loan, you’ll have a ready source of borrowing.

Tax Benefits

Whole life insurance carries with it numerous tax benefits, one of which is the tax-advantaged buildup of cash value. Also, many whole life policies provide dividends representing a portion of the insurance company’s profits that are paid to policyholders. Whole life insurance dividends may be guaranteed or non-guaranteed depending on the policy. The good thing is that even if you are accumulating dividends on the policy, you can defer paying the tax for them. This feature is one of the reasons that make whole life slightly more expensive than both term and universal policies. But take note that the policy is not flexible like the others.

Universal Life Insurance

Universal life falls under the umbrella of permanent life insurance options. It provides more flexibility than whole life.

There are three main components of universal life.

Death Benefits

You can choose from 2 options when determining how you want the beneficiary to receive the death benefits:

• Type A Death Benefit or Level Death Benefit. It’s up to you to pick a level of the death benefit, one that starts off as a single amount and stays level or the same for the life of the policy, regardless of its cash value.

• Type B Death Benefit: The other option is a combination of a specific death benefit and then the insurance company adds the cash value accumulation feature that accumulates over the life of the policy.

The Cash Value Portion

The insurance company allocates a portion of your premiums to an interest-crediting strategy of your choosing. In the basic form of Universal Life, interest is credited at a fixed rate by the insurance company. Some policies, known as Variable Life as discussed below, allow people to invest in mutual funds.

Flexible Premiums

The owner of a universal life policy has the option to pay as much or as little premium above a stated minimum. Although this flexibility attracts many insurance customers, a good percentage find it confusing at the same time. In term life insurance, you pay a certain amount every month or every year and you already know what the death benefit will be. But here, the shifting balances of premiums and death benefits are more complicated than what the majority of people need. Plus, it comes with the same extra costs as other permanent policies.

Another major difference between universal life and whole life policies is that policyholders of universal life can pay the premiums as they desire. However, in order to remain active, the policy must have sufficient available cash value to pay for the cost of insurance.

This isn’t something that you can do with a whole life policy because you can’t change the premiums to suit your present economic situation.

Variable Life Insurance

Variable life is similar to whole life with a different treatment of the cash value component.

In whole life and universal life policies, the fund managers keep the cash value component in a savings account. Although the growth is small when compared to other investment options, there is an assurance of the minimum rate guaranteed by the insurer. The insurance company also makes dividend payments from time to time.

Investment of Cash Value

When it comes to variable life, you’d imagine that it is some type of investment vehicle. The funds are in a mutual fund-like sub-accounts where there is potential for bigger growth. But there’s also the possibility of losing money depending on how the market behaves. The insurance company places the cash value in the stock market. Unlike universal life insurance policies, the insurer of a variable life insurance policy does not guarantee that your cash value won’t decrease.

If you are seeking higher, tax-deferred growth, variable life insurance policies are better investment options than whole life policies because they are like a “super-IRA.” However, you can only invest in the sub-accounts that are available through your policy. You don’t have the option to choose from the wide variety of mutual funds that are on the open market.

While premiums for a variable life can be lower than whole life, it is riskier since the company invests in the stock market. Many people don’t know much about the stock market and don’t know how to properly manage the funds to adjust to the market conditions. An average person won’t have the necessary skills or experience to do it effectively. These features limit a variable life insurance policy as an investment option and as a life insurance choice. The limits on investment choices is common to all permanent policy types.

Cost Comparison

The premium for a term life insurance policy is less than the premium for a whole life policy in the first several years you own it.  As you get older, you are increasingly likely to die so the premium for term life insurance increases and eventually become more expensive than if you were paying for a whole life policy you started buying when you were younger.

Cost of Term Life Policies

You might think that it is a disadvantage to choosing term life. After all, you have to die first to receive money (which does not go to you at all). Every year you will have to keep paying insurance premiums so you can protect your family. The premiums are affordable so you won’t have problems making the payments. But here is where some people can’t reconcile the cost and the benefit: when the 20 years go by and the insured is still alive. The insurance company does not give back anything. The truth is, this is a fair deal because the low premium you are paying only accounts for the death benefit you will get in case you die during the term of the policy.

Cost of Permanent Policies

In contrast, if you had purchased a permanent policy, you could keep it forever. And if you opted to stop in 20 years, the insurance company would likely give you back a portion of the premiums you have paid. When you account for the dividends you’ve received, there is a chance that you’ll get back all your premiums at that point. There is no guarantee that the policy will pay dividends so the insurance companies will not include them in their projections.

In the early years, permanent policies are more expensive than term policies so you would have to consider how much you are able (or are willing) to pay when you choose your life insurance.

About Baruch Silvermann

Baruch Silvermann is a personal finance expert, investor for more than 15 years, digital marketer and founder of The Smart Investor. But above all, he is passionate about teaching people how to manage their money and helping millions on their journey to a better financial future.

Posted on

Top Ten Posts in Our First Year

Financial IQ by Susie Q celebrated its first birthday last week. In the first year, we published 52 posts on our site, two of which were guest posts from other authors, and published two posts on other blogs. In case you haven’t had time to keep up with reading the posts as they are published, we provide you with a list of our ten posts with the highest page views. (We note that there were two periods during which our site wasn’t “talking” to Google Analytics, so there might be a few posts that should have made the top ten, but didn’t.)

#1 Advice We Gave our Kids

This post had almost 1,000 page views in large part because it is the only post we’ve had featured on Money Mix. It provides a list of 7 themes about money that my kids heard frequently as they were growing up or as they were starting to make their own financial decisions. In addition, I added two other pieces of advice I wished I had given them.

#2 Should Chris Pre-Pay His Mortgage

This post was one of my favorite ones to write! Chris @MoneyStir published a post given a lot of detail about his financial situation. He asked others whether their opinion on whether he should pre-pay his mortgage. In my response, I showed Chris that, given his particular circumstances, he would be substantially better off after he fully re-paid his mortgage a large percentage of the time if he invested his extra cash instead of using it to pre-pay his mortgage. One of the broader takeaways from this post is the importance of isolating a single decision and not confusing your thinking by combining separate decisions into one process.

#3 Introduction to Budgeting

Introduction to Budgeting was our very first post. I’m not sure how high on the list it would have been had we published it later, as many of our friends viewed the post just to see what we were doing. I still think budgeting, whether done in great detail or at a high level, is a critical component of financial literacy, so hope that it is valuable to our regular followers and not just our curious friends.

#4 What to Do Once You have Savings

This post is the first in a series of three posts intended to provide a framework and guidance once you have some savings. The series talks about how much to put in emergency savings, how to save for big-ticket items, savings for retirement and deciding whether to pre-pay your student loans. For each type of savings, it provides suggestions for appropriate asset choices.

#5 Getting Started with Budgeting

This post is the first in a series of nine posts on how to create a detailed budget. The process starts with tracking your expenses to see how you are spending your money.  Subsequent posts talk about setting financial goals and figuring out how you want to spend your money.  The series finishes with monitoring your expenses to see how you are doing relative to your budget. This post includes a spreadsheet that allows you to track your expenses.

#6 New vs Used Cars

This post totals up all of the costs of owning a car to help you understand how much better off you might be by buying a used car rather than a new car.  For some cars, it is much less expensive to buy used, whereas for other cars it doesn’t cost much more to buy new especially if you plan to own it for a long time.

#7 Traditional vs Roth Retirement Plans

This post provides lots of information about Traditional and Roth IRAs and 401(k)s. It also explains in what situations a Roth is better than a Traditional plan and vice versa, including some examples. The biggest determinant of that decision is your expectations about your marginal tax rate at the time you save relative to your marginal tax rate at the time you make withdrawals. The post provides lots of information on taxes, too, to help you make that decision.

#8 New Cars: Cash, Lease or Borrow?

This post explains the costs related to buying a new car with cash, leasing a new car and borrowing to pay for a new car. It provides a detailed illustration for three different models.  The best choice among those three options depends on your ability to pay cash, how many miles you plan to drive, and the terms of each individual offer. For some cars and situations, leasing is less expensive than borrowing whereas, for others, borrowing is better. It also provides a spreadsheet that allows you to compare your offers.

#9 Car Insurance

I was surprised that this post made the top 10.  I spent my entire career in the insurance business so probably have forgotten how complicated car insurance is! This post describes all of the important terms and coverages you’ll find in a car insurance policy. It also provides some insights on how to decide what coverages, deductibles and limits to select.

#10 Health Insurance

On the other hand, it didn’t surprise me at all that this post made the top 10. In fact, I would have expected it to rate higher than it did. As with #9, this post explains all of the terms included in health insurance policies. Its companion post explains how to select the health insurance plan that best meets your needs and your budget.  That post includes a spreadsheet that follows along with the calculations. I recently had to select an individual health insurance plan as my COBRA benefits expired.  I used exactly the process described in this post to make my decision!

Posted on

6 Tips About Homeowners and Renters Insurance

Homeowners, condo-owners and renters insurance policies cover you for loss or damage to your property and liability that emanates from your residence.  All three policies cover your belongings regardless of where they are as well as injuries to others that happen at your residence. In addition, a condo-owners policy protects you against damage to the part of your condo that you own (generally the walls in).  A homeowners policy protects you against damage to your home and any other structures. While that seems quite straightforward, there are some nuances that make the coverage more complicated. In this post, I’ll provide you six tips that will help you better understand your coverage.  In the rest of the post, I will use the term “homeowers” to include both condo-owners and renters.

1 – Read your homeowners policy

If you’ve read some of my previous posts (such as this one), tip #1 isn’t a surprise!  An insurance policy is a contract and, like any other contract, I recommend you read and understand it.  To be clear, I’m referring to the 30-or-so-page document with the details of your coverage, not your declaration page which is the 2-3-page summary of what you bought.  I get a paper copy of each of my insurance policies every year. If you don’t get one in the mail, you may need to ask for one or visit your insurer’s website to get a copy.

With insurance, it is a little less critical to read the policy before you buy it, as there isn’t anything you can do to change the policy wording itself.  The wording of personal insurance policies is approved by the state or provincial insurance regulators.  Nonetheless, you’ll want to read your policy to make sure you understand what is and isn’t covered. An insurance policy is actually fairly easy to read.  My recollection from when I took actuarial exams a gazillion years ago is that the policy must be readable at the sixth grade level. So, while it has a lot of pages, it shouldn’t take you more than a half hour to read the policy (maybe a little longer the first time).

2 – Carefully check your declaration page

Your declaration page lists all of the coverages you purchased, the dollar amount of limit you bought for each coverage, the locations that are insured and any endorsements you purchased.  You’ll want to check this document before you buy.   Here are several things to check:

Is the location right?

It probably is. However, I reviewed a relative’s policy one time and saw that his rental property was missing from the declaration page.  If there had been damage to the rental property, my relative would have had to first prove that the insurer or agent made a mistake by not including the rental property and then could have made a claim.  Fortunately, by reviewing the declaration page for him, I found that the rental property had been omitted before he had a claim.

Do the limits make sense?

  • If you own a home or condo, does the structure limit seem reasonable?  Remember it is the cost to re-build your house or condo. For many years, that amount was much higher than I paid for my house, as existing homes were much less expensive than building a new home.  In “hot” markets, the re-build cost could be lower. So, be sure to think about the re-build cost, not the market value.
  • Do you have any other structures, such as detached garages or workshops?  If not, you don’t need much limit for other structures. If so, make sure the limit is high enough to re-build those structures.
  • How much would it cost to replace all your “stuff,” known as personal property?  In most jurisdictions, the personal property limit on a homeowners policy is automatically set to 50% of the limit for the house.  That amount may be right on average, but isn’t necessarily right for each individual. When I lived in California, housing prices were very high.  As a young homeowner, my personal property was not worth anywhere near 50% of the replacement cost of my home. For places with a very low cost of housing, the opposite can be true.  You can’t change the personal property limit in some jurisdictions, but it doesn’t hurt to ask if this limit doesn’t look reasonable. If you have a condo-owners or renters policy, you get to select the limit.  (In Tip 5, I talk about creating an inventory with photos. It will be helpful for estimating your limit, too.)
  • Do the limits on specific items, such as jewelry, musical instruments and collector coins, need to be raised?  Not all policies have the same items with these types of limits, so be sure to check your declarations page if you own any individual items or collections that are particularly valuable.  Most insurers can add an endorsement (essentially a few extra paragraphs that change the terms of your policy) to increase these limits.

Are there coverages you don’t need?

There are a large number of other types of endorsements that either restrict or add coverage.  The names of the endorsements on your policy are listed on your declaration page and the wording should be attached to your policy form.  If not, ask for it! Take a look at these coverages to make sure that there aren’t any that you shouldn’t be buying. I had one relative who reviewed his declaration page and found that he was paying for sump pump failure coverage.  That endorsement covers repairs due to water seepage when a sump pump fails. His house didn’t have a sump pump, so the coverage was unnecessary. It is harder to figure out if there are endorsements you should have that you don’t. If you are insuring your first home or condo, you might want to talk to your agent or insurer to review the types of endorsements available to figure out which ones you might want to purchase.

3 – Make sure you understand what isn’t covered

A homeowners policy does not provide coverage against everything that can happen.  In fact, the policy includes a long list of causes of loss or perils that are not covered.  Many of them are not covered because they are under the control of the insured. That is, if the insured does something to cause a loss or neglects to do something that could have prevented a loss, it is considered intentional.  Intentional acts can’t be insured.

Other perils, floods in particular, are not covered because the potential losses are considered (at least by the government) to be so widespread as to be too big for the insurance industry.  If you live in a flood zone, you can buy flood insurance from the National Flood Insurance Program.

Some perils, such as earthquakes, are not covered because they are so expensive that insurers require you to purchase them separate from the rest of the policy.  By separating the very expensive coverage, the rest of the coverage becomes more affordable. When I lived in California, the cost of earthquake coverage was more than the cost of the rest of my homeowners policy.  In addition, the earthquake coverage had a 10% deductible. I chose to not buy the earthquake coverage because it didn’t fit in my budget. Fortunately, we didn’t have any earthquake damage.

There are several sections of a homeowners policy that identify exactly what is and isn’t covered, so be sure to look for all of them.

4 – Be aware of little extras that are covered

You may be surprised by some of the costs that are insured under a homeowners policy.  You’ll want to make sure you are aware of them so you can recover the full amount you are due from your insurer.   One example is additional living expense coverage.

Additional living expense coverage pays for the increase in your living expenses so you can maintain your normal standard of living if your residence is uninhabitable due to an insured peril.  It also provides coverage if you are required to evacuate due to an emergency. That is, if you need to rent an apartment for several months or stay in a motel for a while, it will be reimbursed by your insurer.  Any reimbursement will be reduced by the portion of your deductible that wasn’t used by the damage itself.

As an example, there was a fire in a transformer in my mother’s condo building.  The building was declared uninhabitable for a little over a week. In addition, the smoke was bad enough that her walls, ceilings and all of her belongings had to be cleaned.  It turned out the ceiling had asbestos that had to be removed. The building insurance covered the asbestos abatement and cleaning, but she was responsible for the rest of her costs so submitted them to her insurer.  Her insurer not only paid to replace her belongings that were damaged by the smoke (such as her TV and computer), but also the cost of her plane ticket to my house for her initial evacuation period and the cost of a residential hotel for a month while her condo was cleaned and abated.

There are several other such extras, including financial loss if someone forges your signature and worldwide coverage for loss or damage to your personal property (not just when it is in your home).  You can find out more about these coverages when you read your policy. (Hint, hint.)

5 – Be ready if you have a claim

A homeowners insurance policy has a list of duties for the insured in the event of a claim.  These duties include promptly notifying your insurer or agent, notifying the police if there is a crime and protecting the property from further damage.  When you have a loss, the insurer may send someone fairly quickly to help you prevent further damage, such as drying carpet and furniture to try to avoid having to replace it or tarping or boarding up windows or roof damage.

Keeping an inventory of your belongings is one of the most important things you can do (and one that I have been remiss in doing).  If part or all of your residence is destroyed, such as in a fire, you’ll need to provide the insurer with a list of what was lost, including the quantity, replacement cost and age.  Obviously, it is impossible to keep a list of every item you own! The most important things to put on the list are those that are valuable – electronics, cameras, furniture, jewelry and watches, collectibles and the like.  It is particularly helpful, especially for unique items, if you take pictures of the items and the receipts and store them outside your residence (e.g., on the Cloud). If you have a loss, you will be able to access that information as documentation for the insurer.

6 – As always, buy the highest deductible and highest liability limits you can afford

A deductible is the amount that you pay on each claim before the insurer starts reimbursing you for your loss.  On a homeowners policy, the deductible applies only to the property coverages, not liability. When an insurer sets the premium for a policy, it has certain expenses and often a profit margin that are essentially percentages of the losses it pays to or on behalf of insureds.  So, if you buy a lower deductible, the losses paid by the insurer will go up. Your premium, though, will go up by the insurer’s estimate of the average amount of insured losses it will cover under the deductible plus the insurer’s additional expenses and profit margin. The additional premium could be 125% to 150% or more of the additional losses.  If you can afford to pay more on each claim through a higher deductible, you won’t have to pay the additional expenses and profit.

If someone gets injured or dies due to a condition that exists at your residence, you may be legally responsible for their medical expenses, lost wages and other costs.  If those costs are more than your liability limit (including the limit on any umbrella insurance you buy), you will become legally responsible for those costs. A higher liability limit can reduce your chance of becoming liable for these types of costs.  Of course, a higher limit also increases your premium, so you’ll need to evaluate both your deductible and the premium for a higher limit in the context of your budget.