A Suze Orman exclusive
This one doesn't need to be nearly as complicated, expensive, or daunting as you probably think.
First, the only reason you need life insurance is if anyone is dependent on your income. That can be kids, a spouse, a partner, an elderly parent. If no one is dependent on you, then you don’t need it. That simple. And please, you new parents, do not let anyone talk you into buying a life insurance policy on your child. Remember, the point of life insurance is to replace income that would be lost if the policyholder dies. Working from the assumption that your kid isn’t Dakota Fanning, there’s no need to buy a life insurance policy in your kid’s name, since your kid doesn’t produce any income you depend on.
Next, you should only look for one type of coverage: Term life insurance. Do not—I repeat, do not—buy any other type of life insurance. There’s another kind, called “cash value,” which is a colossal waste of money, if you ask me. These cash value policies come in a variety of flavors, including whole life, universal life, and variable life. Just say no to anyone who tries to talk you into one of these plans. They can be more than 10 times as expensive as a term policy, yet you don’t need any of the “extras” they come with. In fact, the big added feature of a cash value policy is that it provides an investment component. I won’t go into a ton of details here other than to tell you that a life insurance policy is a lousy way to save and invest. So stick to a policy that simply provides life insurance and leave off all the expensive bells and whistles.
If you have already bought a cash value policy, I recommend canceling it and getting term life. Just don’t cancel that old policy until you are fully approved for the new one. If you took out the cash value policy many years ago, or you now have a pre-existing medical condition, you may find it hard to get a cost-effective term policy. In that event, your only choice is to stick with the cash value policy.
A term policy provides your beneficiaries a death benefit (the payout on the policy) if you die while the policy is in effect. As its name implies, your policy is in force for a specific length of time, or “term.” You want to make sure the term you choose matches your needs. For example, if you have a two-year-old child, a 20-year policy will provide coverage until your child is through (or close to through) with college. If you have a 13-year-old, a 10-year term policy will suffice.
Now for the size of the death benefit. No need for crazy calculations. We can keep this part simple too: Buy a policy where the death benefit is equal to 20 times the annual income
your beneficiaries would need to support themselves without you. Why 20? Well, I believe you owe it to your family to be super-careful here. I want your beneficiaries to be able to live on that payout without having to touch the principal; the peace of mind this provides is priceless. So if your policy is 20x their annual needs, that means the payout could be invested in high-quality bonds earning 5 percent or so in annual interest. The interest income would produce enough for them to live on.
How about an example? Let’s say your spouse and kids would need (before taxes) $50,000 a year to live on. Multiply by 20 and we come up with $1 million. Don’t get all grouchy and think you can’t afford a term insurance policy with a $1 million death benefit. A healthy 40-year-old male can get a 20-year policy for as little as $80 a month. For a 30-year-old the monthly premium can be as low as $50 a month. Come on, that’s doable!
Now, if you were to die during that 20-year period, your beneficiary would receive a $1 million payout. If he or she then invested this lump sum in high-grade bonds earning 5 percent, the annual payout would be $50,000, without touching principal.
Maybe plenty of people will tell you I am going overboard with the 20x rule. Quite often you will see advice saying that all you need to “replace” is a few years of income or to just buy a policy that is equal to no more than 10x your beneficiary’s annual income needs.
I don’t think so. Never forget what has to happen for your beneficiary to collect on your policy: You have to die. It doesn’t get any more traumatic than losing a loved one and a provider at the same time. So what happens if your beneficiary isn’t in any shape to continue working, or if they’ve been out of the job market for years, or if they are simply too distraught to get a full-time job for a long while? They may even have been with you in a terrible accident and now have physical disabilities that prevent them from working to support themselves and the children.
My point is pretty simple: Why not give those you love the utmost financial flexibility in the event you die prematurely? Given the low cost of term insurance, you can buy them a ton of flexibility without breaking your bank account.
And one final life insurance tip: If you or your partner is a stay-at-home parent, please make sure you also have a term policy on their life, too. In the event the stay-at-home parent were to die, the surviving partner would need extra income to be able to pay for childcare. So tie the death benefit amount to what you expect your childcare costs could be and how many years you anticipate your kids would need that care.