Not long ago I was considering whether to decrease my life insurance coverage through my employer. We have an Employer based Life Insurance Policy and a separate Term Life Policy. The following is a culmination of that investigation.
Employer Life Insurance Policy
If you work for a large company you likely have some sort of Life Insurance buried in your benefits. It is most likely 1x your pay. This should be enough to allow your significant other to recover from the initial shock of your death and pay for burial. The bigger issue is your spouse has now lost access to your income. The 1x your pay is not enough to replace the missing income over the subsequent years. This is fine if you do not depend on your spouse’s income, but otherwise will leave you in a world of trouble. As such if you’re married with kids, or have any other dependents, I would recommend increasing your life insurance beyond this point. You do not want to have those who are left behind struggling to make ends meet on top of mourning.
While I advise purchasing more life insurance I believe it is better to purchase additional coverage outside your employer plan for 2 reasons. Consider shopping both within and outside your employer plan for the following reasons:
- While Life Insurance in amounts below 50K paid for by your employer are tax free, the cost of a benefit exceeding this amount if paid for with pre tax funds are taxed as something called Imputed Income. Essentially tax is added based on the coverage over 50K divided by 1000 multiplied by a value in the below table. The table amount is chosen based on your age and multiplied again by 12 months. Finally the resulting value is subtracted by any portion you personally chip in after tax. This amount is then taxed as ordinary income. This may make the life insurance more expensive through your employer after accounting for discounts from insurance bundling via a private carrier. In the past I have had cases where adding life insurance to my car insurance company resulted in a discount on car insurance roughly equal to the cost of the life insurance policy.
Imputed Tax=((Total group term coverage – $50,000) / 1,000) x rate for employee’s age from table below - employee after-tax contributions for the year x 12 months
Age Cost Factor per 1000 per Month Under 25 0.05 25 to 29 0.06 30 to 34 0.08 35 to 39 0.09 40 to 44 0.10 45 to 49 0.15 50 to 54 0.23 55 to 59 0.43 60 to 64 0.66 65 to 69 1.27 70 and older 2.06
So, a quick example. If I am 35 and I have 100K in coverage, then my imputed tax would be (100K-50K)/1000*.09*12 or 54 dollars. Not a huge dollar value but greater than 0.
- Not all Life Insurances persist when you leave an employer. Before counting on an employer life insurance policy you should check if it will be possible to continue should you leave your employer without an additional health screening. You should also check what the rate will be in this case. The last thing you would want is to have an illness force you from a job and then no longer be able to get insurance.
We currently keep 50K in Employer Life Insurance, thus avoiding any imputed taxation.
Term Versus Whole Life
If you do decide to purchase coverage outside your employer you must choose between Term and Whole Life Insurance.
Term insurance is purchased to cover a period of a number of years, with the most common being 20 or 30 years. Generally these policies are cheap and are purchasable with a fixed premium over that term. Some companies will even adjust your payout amount for inflation, commonly called an inflation rider, for a larger fee.
Meanwhile, just as the name implies Whole Life Insurance is purchased for your entire life. Usually Whole Life not only insures you for your entire life but also accrues a cash surrender value. That cash accrual usually occurs at some fixed rate plus a variable amount acting as a kind of savings account. Often times the dividends off this cash surrender value can be used to pay your premiums once you’ve held it long enough. This is most likely the case if your parents, like millions of others, bought you a policy as a kid. Be sure to check with your parents if you have such a policy as they are often forgotten.
Insurance should not be an Investment Vehicle
In theory the Whole Life Policy is a better deal, but in practice it is almost always not. The biggest issues are :
- A low rate of return compared to the stock market or other investments. Essentially Whole Life Policies are invested in low risk investments for the insurance company to ensure they can pay your premium. As such they will lag riskier assets like the stock market.
- Typically High fees, which eat into the returns. Fees on whole life policies can be excessive, they are also not easily comparable to other investment options. They can include sales commissions and ongoing costs.
- You may not require insurance for your entire life. At some point you may become financially independent. That point when your dependents are out of the house and you have enough to retire and no longer work. At that point there is no longer a reason to buy life insurance. By buying a whole life insurance policy you are also paying for that period of your life whether you need it or not.
- Counter Party Risk. If the insurance company becomes insolvent you could see an increase in fees or a decrease in cash value. You are betting on the long term health of the insurance company. Note there are state level protections to ensure your entire policy remains in tact, but as noted the terms can change.
Why Whole Life Insurance Returns So Little
For those who view whole life insurance as an investment in your heir’s future, for the above reasons I ask you to reconsider. If you do not need it to allow a dependent or spouse to solider on in your absence, it is highly likely your dependents will be better served by other investments. After all, if it was such a good deal over other investments the insurance companies wouldn’t sell it.
Why? They have to invest your premium behind the scenes to keep themselves in existence and make a profit, they do so by investing in low risk assets. They have access to the same underlying investments you do. Thus their product’s return must always be at least lower than your potential investment returns by their overhead plus whatever profit the company makes. If a salesmen earns a commission the rate of return could be even lower.
How long a Term to Buy
So basically that leaves us with a purchase of Term Life. In order to determine the correct term for you, evaluate how far into the future you will have a dependent depending on you. Also, consider at what point you and your spouse will be financially set to retire. (Note for the purposes here I mean retire with no more work, not retire with side gigs). Calculate out when that leaves you and buy a term that matches that time period. The shorter the period the lower the cost. I currently carry 20 years of Term Life. This will carry me to my oldest son’s senior year and my youngest’s freshman year of college. At that point I expect to be sunsetting my career. I had considered 30 years but ultimately I decided based on my current financial trajectory this was a safe point to stop coverage.
How much Life Insurance should I Buy?
The final question is how much? Some would like enough to retire should their spouse pass, which would be your retirement number – your current net worth. However, I would personally recommend at least 5x your pay. This means for 5 years the missing pay will not be noticed. My rationale is 5 years is long enough for my wife to modify her career trajectory to account for my missing income. That being said my wife has an engineering degree and a successful career history to fall back on in my absence. If that is not the case you might be better off with the retire approach. Ultimately, this is a deeply personal question you should discuss with your partner.
What type of life insurance do you carry?