In last week’s column, we covered how to create a retirement plan and began a discussion of how to cure a negative cash flow should your newly identified investment goals’ costs create one. I defined three processes for curing a negative and covered the first one in that column. Therefore, in this column, I will cover the final two.
Saving on insurance
The second process for curing a negative cash flow is reducing insurance premiums. Insurance is a category of expenditures where overspending is very common. I recommend you look at all areas of your insurance needs by developing a Personal Security Formula as discussed in much greater detail several weeks ago in my columns on this topic.
As a brief review, the Personal Security Formula creates a system of defenses that will eliminate all vulnerability in your long-term financial planning.
For most people, there are five areas of vulnerability:
1) Death of the main breadwinner.
2) Disability of the main breadwinner.
3) Major illness of a family member.
4) Casualty loss – home, car, personal possessions.
5) Personal or business liability lawsuit.
Each of these areas of vulnerability can and should be covered by insurance.
Determining life insurance needs
The only way to determine how much life insurance you really need is to assume that your family’s main breadwinner died last night. If that happened, you would find that there are four main financial problems that would need to be solved:
1) Estate Liquidity
2) Survivorship Income
3) Special Obligations
Estate liquidity pertains to all the expenses immediately related to death, including estate taxes, probate fees, attorney fees, accounting fees, appraisal fees, funeral costs and last expenses. Since you can now leave almost $5.5 million estate-tax free to your heirs ($11 million if you are married), a good general rule of thumb is to allow for $50,000 worth of expenses or 6 percent of the net estate, whichever is greater.
For larger estates, please see an attorney specializing in estate planning.
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How much of the main breadwinner’s income would you want to replace should that person die prematurely? The chart below will help you come up with a close estimate of how much you would need to invest at 8 percent in order to provide an annually inflating income stream. It is based on a survivorship income need of $1,000 a month. For higher levels of income, simply multiply the figure by the appropriate multiple. For example, if your spouse is 45, you would like him/her to have $2,500 a month in survivorship income, and you are using an inflation rate of 6 percent, multiply $298,286 by 2.5. Your survivorship income need is $745,715.
This category includes such items as a college fund for your children. If you were to die before they enter college, you could ensure that they will have enough money to go to school by factoring that need into your life insurance. Here is a simple way to run the calculation. Long-term CD rates tend to mirror the inflation rate. Therefore, if you had a sum of money large enough to cover today’s cost of tuition bills and you invested that amount in a log-term CD, it would keep pace with inflation. The only problem is that the money earned in the CD is subject to tax and inflation is not.
So here is what to do: Take the total current cost to fulfill this education goal and divide the reciprocal of your tax bracket into that number (i.e., if you are in the 15 percent tax bracket, divide by .85; if you are in the 28 percent tax bracket divide by .72; and if you’re in the 33 percent tax bracket divide by .67).
For example, if you wanted to provide today’s equivalent of $36,000 in college assistance and you are in the 33 percent tax bracket, divide .67 into $36,000. The answer is 53,731. You should allow for $53,731 in life insurance proceeds to cover the cost of your children’s college education fund.
The main breadwinner’s salary is required to pay for such items as the house mortgage and car payments. If that person dies, you may want to have enough life insurance money to pay off such items entirely. Therefore, ask yourself if the main breadwinner in your family died, which liabilities would you want to be able to payoff’?
Totaling your life insurance needs
Now add up the various categories to determine your total life insurance needs:
Estate Liquidity _________
Survivorship Income _________
Special Obligation _________
Subtract Hard Worth (explained here) _________
Total life Insurance Need _________
In next week’s column, we will discuss term verse whole life insurance, and when each is the best solution based on a specific need.