As my wife and I move along on our journey to Financial Independence (FI) while thinking about starting a family, we’ve been wondering about getting life insurance. It feels like one of those things we “should” do, but does it really make sense for us? Does it make sense for anyone pursuing Financial Independence?
Life insurance is a bewildering, fear-driven world that, until recently, I didn’t know enough about to think systematically. This post is going to introduce a few systems that have helped me think about life insurance: how to determine how much you need, how seeking FI impacts your needs, and how to build an affordable life insurance plan.
The DIME Method
Earlier this year, I heard an independent insurance rep present a system for calculating your life insurance needs called the DIME method. There are a lot of resources online to learn more, but it roughly breaks down as follow:
- Debt Payoff: avoid leaving any debt for your family; calculate how much you owe in consumer debt such as credit cards, student loans, etc. Include enough to cover your final funeral expenses too.
- Income Replacement: provide sufficient income for your family to maintain its standard of living. Typically, this is a multiple of your annual income, say 10x income. However, as the FI crowd knows, it should be a multiple of your annual expenses, not income. If this is 25x or more of your annual expenses, then should be enough for your family to live without working for the rest of their lives; see the Trinity Study and the 4% Rule for retirement.
- Mortgage Payoff: a home is typically a family’s largest purchase, and a mortgage is its largest debt. If you’re still paying off your home, then you should include your outstanding mortgage balance in your life insurance plans. This way your heirs inherit your property fully paid-off and can either live in it debt-free, rent it out for additional income, or sell as they wish.
- Education Expenses: if you have kids, you probably want to ensure that they can afford a high-quality education. With rising college costs, I personally think this is the hardest need to predictably estimate.
With the DIME method in hand, I can start thinking about how to best insure my family.
Term vs Permanent
The next big question was the inevitable term insurance versus permanent insurance debate. We’ve all heard the horror stories about insurance salesmen swindling people into buying expensive permanent policies and generally over-insuring for their needs. While there’s certainly some truth to this, after calculating our own life insurance needs, I can see why the insurance industry claims that most people are far under-insured.
The most common cry against permanent life insurance from the personal finance world is to “buy term and invest the difference!” but this ignores the well-known truth in behavioral finance: most people won’t actually invest the difference. This argument parallels the “a house is a good investment” argument; both permanent life insurance and owning your home are good investments only in that they act as a forced savings plan for those who otherwise wouldn’t save much of their income.
If nothing else, the whole-life argument that “most people don’t actually invest the difference” doesn’t really apply to people pursuing FI. Maintaining a high (~70%) savings rate is already super important to us, we’re just trying to find the best location for these assets. As I mentioned above, this argument is basically just a forced savings plan, one with particularly complicated terms, high fees, and inflexible low-return investment options.
Obviously, we all want the most bang for our buck. The main concept we’re going to consider here is to “layer” multiple life insurance policies for different needs. To begin thinking through the permanent versus term question, let’s break down the DIME method into its root needs. Debt isn’t (or shouldn’t be) permanent, nor is a mortgage, and at some point, your kids will be grown, educated, and (hopefully) living successful independent lives. The only permanent need identified in the DIME method is income replacement. If you plan to retire at a typical retirement age of 55-65, then permanent life insurance may be a good choice for this portion of your life insurance needs.
My family is aiming for early financial independence (FI), which is shockingly simple by focusing on your savings rate, so we’re effectively self-insuring the income portion very early in our lives with plenty of time to course correct and adjust as necessary. For those seeking early financial independence, using permanent life insurance for income replacement doesn’t make sense. Instead, you should buy a term policy to cover you until you expect to reach financial independence; once you’re financially independent, it doesn’t make sense to insure an income stream that you don’t need to live on and may not even have any more if you choose to stop working.
Other Uses for Permanent
So then what else is permanent life insurance good for? Is there a place for permanent life insurance in the FI family toolbox?
There are certainly use cases for permanent insurance other than income replacement, but they don’t necessarily apply to most families pursuing early financial independence. And in many of these cases, there are more affordable alternatives than a permanent policy for these needs. That being said, here’s a list of the more common use cases I found and other alternatives, where appropriate. (Disclaimer: I’m not a lawyer, accountant, or tax specialist; just a guy with the internet.)
- estate taxes: only affect those with greater than $10 million in assets for a married couple federally and $8 million as a couple in our state
- liquidity issues: if all of your assets are tied up in real estate, a family business, or other “illiquid” assets, and you expect this to remain for most of your life, then you might need permanent life insurance. Personally, our liquid net worth is 80% of our total net worth right now so this isn’t an issue for us.
- tax-free asset transfers to the next generation: if you have a lot of assets that you want to leave to your kids or grandkids in a tax-efficient manner, a permanent life insurance policy may help. Personally, we don’t have sufficient assets for this; if and when this is an issue, there are cheaper methods that we would discuss with an estate attorney, e.g., give tax-free gifts every year or use a family limited liability company with liability discounts to gift appreciated assets.
- borrowing against your policy: many permanent life insurance “solutions” tout the ability to borrow against your policy. There are cheaper options, however. Sell shares in your taxable account with the smallest capital gains and pay no interest; for comparison to non-direct recognition policies, you could borrow on margin with a trading account for approximately the same interest rate or apply for a personal loan secured by your brokerage, which is basically how the cash value is being used in this case anyway.
- tax advantaged cash value: while this is true, it should be considered after all other tax shelters are exhausted, including maxing out company 401k/403b, solo 401k with up-to $53k employer contributions, backdoor Roth IRAs, HSA, profit sharing plans, etc
- creditor protection: federal statutes protect 401k/403b/IRA/Roth IRA/etc, so it only makes sense to use life insurance for this after maxing out all other tax shelters; protection for permanent life varies by state; you would also need to compare to an irrevocable living trust, etc. to determine if this is a good use case.
- disability protection: many salaried jobs include some form of disability protection in their free group policy or for a very-low cost. We have disability through our jobs while we need them; once we’re financially independent, we don’t need disability protection anymore (since its designed to replace income in the event of a disability).
- dividends return on premium: dividends paid by investments held within your life insurance policy can sometimes be treated as a return of the premium you pay which is an un-taxable event. However, you can achieve similar outside of life insurance if you structure your finances so that you control a lot of assets but have relatively low taxable income, using real estate depreciation for example, then most of your dividends could fall into the 0% and 15% dividend/capital gains ranges; not as nice as return of premium, but much better than ordinary rates. With certain asset classes such as acquiring a small business, you may be able to claim return of premium on your initial returns.
If any of these cases may fit you, I highly encourage you to consult with your attorney, accountant, financial planner, and insurance agent to work out what’s best for you and your family. For now, I haven’t found any of these “exceptional” use cases that particularly fit our needs either.
Life Insurance for those seeking FI
Okay, so now we know that we don’t have any current needs for permanent life insurance. Term can serve all of our purposes. Next we need to identify one or more term policies to fulfill all of the life insurance needs we’ve identified.
Using my own family as an example (with a bit of fudging on the numbers), here’s what we need:
- Debt: we pay off credits cards every month, so we’re not carrying any consumer debt. While we’re working, both our companies provide us with a free $50k group policy. Once we’re post-FI, we could afford $15k out of pocket for unexpected funeral costs or we may consider a small single-premium $15k permanent policy for our final expenses.
- Income: say we spend $40k each year, then we need (40,000*25=) $1,000,000 to be financially independent. If we have a $250k investable net worth, our insurable need would drop to $750,000 remaining. Notice how our insurable need drops as our savings increase; there’s something called a “decreasing benefit” policy that may be a good fit. If we each make $50k/year and can live on one salary (saving $50k/year), then it should take us another 14 years to reach FI. We should consider a 15 year or 20 year term policy based on the quoted insurance rate and our confidence in reaching FI within a 15 year time frame.
- Mortgage: assuming we own a $300k home with an outstanding $250k mortgage payable over the next 28 years, we’d want a $250k 30 year policy. If we can find a good option, a “decreasing benefit” policy would be a good fit here too.
- Education: we don’t have children yet, but a reasonable assumption would be to expect 2-4 kids in the next 2-8 years. This means that their “college years” should all be completed between 24 and 30 years away. Here’s where big assumptions come into play; if we assume a four-year university education at a state school currently costs $100,000 and that the cost of college increases faster than inflation (say 4% instead of 3%, as per the 2012 Yale Endowment Report), then in 24 to 30 years the price will be $250k to $325k per child. If we have 2-4 children, the insurable need ranges from $500k to $1.3 million. With such a large range of uncertainty in our insurable need based on unknowns in when and how many children we will have, a reasonable option would be to wait to buy a separate policy for education, either individually for each child as he/she comes along, or collectively by buying the initial policy with a rider that allows us to increase the benefits at a later date without an exam. However, if the rate is right, we could always buy a “starter” policy now while we’re under-30 and healthy to lock in a premium; it doesn’t cost anything to cancel a term policy should we not need it later on.
From the above discussion, it sounds like the ideal structure would be 3 policies, one for each need: a $750k 20-year term decreasing-benefit term policy for income replacement, a $250k 30-year term decreasing-benefit term policy for the mortgage, and a $500k 30-year term policy for education with a rider to increase benefits without a new medical exam.
Of course, who you carry these policies on is a big question for a family or married couple. Ideally they’d be joint first-to-die policies, so that if either one passes away, the other is immediately financially independent. I’m not sure if these policies exist in the types that we want, for example, a joint first-to-die decreasing benefits policy. I’ve just sent an email to the independent insurance agent from the beginning of the article for clarification. Update to come.
Do you know of other use cases for permanent insurance for FI families?