Calculating Your Life Insurance Needs

Start with a no-frills plan and keep in mind that each frill raises the premium.
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Last week, I discussed in general terms how to determine your need for life insurance. Now it's time to put a dollar figure to your needs.

Calculating the amount of income your life insurance policy needs to produce for a surviving spouse or family member can get tricky.

When calculating your beneficiary's income needs, be realistic and start with a no-frills budget. Or if you want frills, just remember they will raise the premium.

Once you've calculated an amount, the next step is to reduce it by the amount you expect the survivor to earn. Let's say you arrive at an annual need of $42,000 a year for a surviving spouse. If the spouse works and makes, say, $20,000 a year, that would leave $22,000 for the insurance policy to pick up.

The third step is to credit any other sources of income. If you have $100,000 in investments, for example, you might credit 6%, or $6,000 annually, as income. That would reduce your survivor's income need to $16,000 a year. (You also should determine whether to include Social Security in your calculations. In this example, I am not including it.)

The simplest way to fill a need for $16,000 of income is a life insurance policy that will supply adequate capital. In this case, that would require an insurance policy paying a lump-sum benefit of about $270,000 when you die, assuming your beneficiary wanted to withdraw 6% annually while preserving the capital.

If you have enough in investments to provide the necessary income, in this case $270,000, you don't really need the insurance for this purpose.

That brings us to another very important principle. As you have more money building up each year, you have less of a need for life insurance to meet future needs. As a practical matter, you probably wouldn't reduce insurance every year, but you should review it annually and maybe drop some every third year or so.

Estate Taxes

The need relating to estate taxes is a different kind of need. Once you no longer need insurance to ensure somebody's livelihood or survival, the decision to use life insurance to pay estate taxes is more of a business decision. You need to talk to an estate planning attorney to find out what your approximate estate tax will be, and you need to plan with the attorney to reduce the potential tax. Estate taxes can be as high as 55% in some cases. If you are married and the proper kind of trusts are established -- sometimes called credit shelter trusts -- you could eliminate all federal estate taxes. (See a recent

Fund Forum for more on trusts and estate taxes.)

Let's assume that after all the planning is done, you will owe $100,000 in estate taxes. What is the best way to pay those taxes? Surprisingly, many people have told me they don't care if the $100,000 is paid out of the estate. They simply are not worried about the beneficiaries losing it, and they don't care if the government "confiscates" it. For these people -- right or wrong -- the decision has been made.

Other people will evaluate their alternatives. Is there some way to "discount" the $100,000? There used to be two ways to effectively discount the bill: flower bonds and life insurance. I am told that there are not many flower bonds around and that the government stopped issuing them. The concept of flower bonds helps define how the life insurance can work. For example, a few years ago, you could have paid $70,000 for a $100,000 face value flower bond. When a person holding the bond died, the bond would "flower" to full maturity and pay $100,000. Since the person paid only $70,000, it amounted to a 30% discount and the money was used to pay estate taxes, thereby discounting the estate tax bill.

A similar strategy can be used with a cash value whole life or variable life policy. The policy needs to be a "permanent" one. Term insurance will not work here. As long you are insurable, this can be used effectively at any age. Such a policy would be issued for $100,000. The insured would pay premiums over time and probably could stop paying at some point. That point would probably be when there is about $70,000 or less in the policy. At death, the amount "flowers" to its face amount, and the beneficiary is paid the full $100,000. Again, in the example, the discount amounts to $30,000, or 30%. Because it is an insurance policy, the proceeds are income-tax-free. They will also be free of estate tax if owned by a trust or, in some cases, by adult children.

Business Partnership

The last life insurance need I want to mention is for funding a purchase and sales agreement between partners or owners of a business. To keep it simple, let's say there are two partners, both married. Neither spouse works or desires to work in the business. The partners agree that if one of them dies, the other will pay the surviving spouse for the deceased partner's share of the business. To accomplish this, the partners will have to get an appraisal of the value of their business. They also would need to develop a formula to keep the valuation up to date. The estate planning attorney would then draw up a formal agreement. The partners would have an insurance policy on each other so the cash would be available if either were to die. While they could use money from the business to fund the buyout, the life insurance would have the effect of discounting the payment, similar to the "flower bond" principle for estate taxes. The end effort is that the surviving spouse gets the cash and the surviving partner owns 100% of the business.

Please realize that planning for some of these needs is not always simple. You generally need a good estate planning attorney, a professional life insurance specialist and a fee-only financial planner overseeing and coordinating the process with you.

You have done it again -- lots of wonderful email! Many of you have specific questions and comments. Some of you have wonderful examples of how your planning has worked. Before I leave this subject, I want to try and work some of your comments into a column. Next week, I will discuss the type of insurance you may need. Should you have term insurance, whole life, variable life or variable universal life? Remember, regardless of the heated debate on the kind of insurance, the important point is to have it when you need it.

Please keep the email flowing. Invest for the long term and be healthy!

Vern Hayden is a certified financial planner with American Planning Group in Westport, Conn. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at