Typically insurance salesmen will tell you that when buying life insurance, sooner is always better than later, as there is a risk that a health issue will drive your premiums up in the future or even bar you from getting insurance all together. Having sold life, disability, and long term care insurance through Northwestern Mutual, I am privy to the most common sales tactics and, while I am not saying these reasons for getting insurance asap are incorrect, I would like to put a different spin on figuring out how much insurance you will need and when you should buy it.
The industry norm for estimating life insurance needs is to add up the total debt of your household (including mortgage, credit cards, etc.), extraneous needs for children such as a college fund, and finally lost future after tax income of you and your spouse in the event of death (when estimating life insurance coverage for yourself, use your own future after tax income expectations; when estimating coverage for your spouse use his/her future after tax income expectations). Estimating buy life insurance needs in this manner, while it seems logical, ends up double counting expenses and results in giving you more insurance than you may actually need.
When should I buy life insurance?
If you are in good health, there is little need to buy life insurance before you have a need for it. I like to think of life insurance in terms of obligations; if you take on obligations with another person, such as a mortgage or having children, that is the time to purchase life insurance for yourself on your half as well as insurance on your spouse’s half of that obligation. While there is always the possibility that for health reasons you may not be able to get insurance down the road, that possibility is very small; the bottom line is that insurance companies know that if they can get you to sign up with their company now they will likely be your go to company in the future. For that reason it is better for them to get you to sign up before you actually start shopping around for options. From prior experience, I believe that each client is expected to produce an average of 7 return sales after the first, meaning that gaining you as a client is an insurance salesman’s number one goal, even if the first sale is small.
As soon as you start taking on obligations with another person, you should assess what your and their part of the obligation is based on your and their percentage of total household income. If you make $30,000 after tax and your spouse makes $40,000 after tax, you can assume that you have 43% of the obligation while your spouse has 57% of the obligation. If you buy your first home before having children, there is no need to insure both your and your spouse’s after tax income at this point. Simply calculate what your percentage of the obligation is using your portion of household income, in this case 43% (say you and your spouse took on a $300,000 mortgage. Your part of the obligation is $129,000 and their part is the difference).
When you and your spouse have children, you should again calculate what the total obligation is and insure both your and your spouse’s portion of the obligation. At the point of having children, chances are that with car payments, childcare payments, retirement contributions, and mortgage/rent payments you and your spouse have accounted for most of your and their after tax income with some sort of obligation. At this point, instead of estimating the future cost of each child, you can use your and your spouse’s future after tax income to estimate your insurance needs.
How much insurance do I need?
Obligations you will want to insure include debts (obligations made to the bank), retirement and living expenses (obligations to your spouse), and childcare (obligations to your children including food, activities, college etc.). If you insure your and your spouse’s after tax future income through the lives of your children, you have already covered what your and your spouse’s portion of the mortgage/debt payments would be in addition to your and your spouse’s part of monetarily raising the children and sending them to school.
If you and your spouse are covering your obligations with your total after tax income, you should need no more coverage than your future after tax income. By adding on enough insurance to cover the house and college for your kids you are double counting what future income should have already been able to cover. Remember that insurance is paid out in a non-taxable lump sum. Even if you only included your future income, the lump sum should be plenty to provide you or your spouse with enough money to sell the home he/she currently occupies and take out a new mortgage on another home. Giving you or your spouse future income on top of enough money to pay off all debts is unnecessary. That said, the amount of insurance you should purchase is somewhere between your part and your spouse’s part of your obligations and your and your spouse’s future income. There is nothing wrong with purchasing more insurance than this, but why not use that extra money you will save in insurance premiums having fun while you are still alive as opposed to giving it to the insurance company.
Is buying life insurance enough?
Many people understand the need for purchasing life insurance, but in my experience, pre-counseling on how the insurance would be used in the event of death is lacking. Sales tactics we used included asking people how their spouse would make mortgage payments or raise the children if they were to die. While this is useful in getting people to see the need for insurance, it does not help the spouse actually spend the money wisely in the case that you do in fact die and your spouse receives a lump sum insurance check. What if your spouse thinks it’s a good idea to buy a larger home or a new car instead of investing the money and taking withdrawals periodically to pay for your portion of the household obligations?
A lump sum of money can be very difficult to manage, especially for someone who has not had a large amount of money in the past. That is why I recommend getting financial counseling before even purchasing life insurance. Your insurance agent may be able to provide council or even refer you to a more experienced investment advisor who could help you. The bottom line is that you don’t want to spend more than your spouse’s annual after tax income out of your lump sum. Both you and your spouse should understand how the money would be spent in the event of death so that in the unlikely event that one of you dies, the money will last until all of your children make it out of the house before the lump sum is depleted.
Buying insurance is an important part of a balanced financial plan; however, you probably don’t need to buy life insurance before you take on obligations with someone else. In addition, don’t let a salesman make you think that covering your future after tax income is not enough (this is the LAST thing on the list of insurance needs on the form I used to have potential clients fill out, but in reality if you are using future after tax income in your estimation then you don’t need to include your mortgage, future education costs for kids, etc.; remember that your income would have covered your part of those costs).
If your obligations with your spouse are less than your future income, go ahead and only insure your part of those obligations and get more insurance when the time comes that you take on more obligations. When you wait to get life insurance you are taking a very small chance that a health issue may keep you from getting additional insurance in the future, but insurance agents typically blow that chance way out of proportion.
Selecting how much insurance to buy and when to buy it can be difficult, but armed with a bit of knowledge, you will be able to ask your insurance agent the right questions and make sure you don’t end up with too much life insurance too early.
Have you had an experience either buying or selling life insurance? Please share your thoughts in the comments.