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The Risk of Dying

When it comes to financial planning, death is often a risk. Fortunately, that risk can usually be offloaded to an insurance company.

But should you? Is life insurance worth it?

Here’s my overall perspective on the matter: You should spend your last dollar on life insurance in some instances and not even your first in other cases.

Life insurance is a tool to manage risk. And it’s really good at that. However, it’s not nearly as effective as an investment tool or even a tax avoidance tool in most cases. But I see a lot of life insurance policies put in place to do more than manage risk. That’s often a mistake.

People typically have three questions when it comes to life insurance: Do I need it at all? If I do, how much do I need? And what type of policy is best for me?

Those are excellent questions. In fact, they are the only ones that truly matter.

The first question is relatively simple to contemplate. If you were to die, would your family be able do all the things you want them to do? Would they be able to stay in the same house? Would they be able to pay down other debts? Could they still go to the same schools or universities? Would retirement for a surviving spouse still look the same?

If you die and the family can still manage all those things with existing financial resources, you likely don’t need life insurance at all.

The second question is also simple to understand – although it takes a bit of guesswork and math to answer. The first step is to project your family’s expenses from now until kingdom come. The second step is to compare those expenses to the family’s expected income each year. That’s not exactly easy to do with any degree of precision. But precision isn’t necessary – you just need to get the big things right.

If there are any gaps in your projections, where expenses exceed income – and there are no other financial resources to fill the gap – that’s a very good indication that life insurance is necessary.

And keep in mind, there are rules of thumb. So if making income and expense projections and employing a bit of math seems tedious, it’s not wrong to take a shortcut. Some say to multiply your income by 10 to determine the right size for a death benefit. Sure. Others say to have a death benefit large enough to pay off all debts, including mortgage and funeral expenses, add all future education expenses for kids, and tack on the annual income support required for the family multiplied by the number of years it is needed. Okay.

When it comes to life insurance, I’d rather be approximately right than precisely wrong.

That brings us to the third and final question. What type of policy is best for me?

It’s always dangerous to generalize, but I guess I’ll live dangerously. I would say for 80% of people the right answer is term life insurance. It’s the cheapest and purest form of life insurance.

The vast majority of us need life insurance while we are young but eventually grow out of the need as our assets accumulate. That’s the perfect profile for a term policy.

But not everyone fits that mold.

If you are in business with someone else, there is a good chance you need permanent life insurance. If you have a farm and some children work on the farm while others do not, and you want their inheritances to be roughly the same, there may be no better solution than permanent life insurance. Even for certain estate tax scenarios, permanent life insurance has its place.

It’s important to have the right policy because the cost of having the wrong policy can be steep. Either you end up paying too much in premiums or you lack the coverage you need when you need it.

Life insurance, like any tool, has its place. But it should be utilized for its highest and best use – to manage risk.

Beyond that, there are likely better options.

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