If you’re underinsured, you and your assets may be at risk. Here’s how to determine if you have the right amount of life and disability insurance coverage.
Warren Buffett famously said, “A rising tide floats all boats. Only when the tide goes out do you discover who’s been swimming naked.”
Of course, it’s easy to see how this quote applies to investing. When the market is up and stocks are performing well, risk management tends to be less of a priority.
Only when markets turn negative do investors focus on managing risk again. Yet by then, it’s often too late.
The same is true for insurance. When you’re healthy and your assets are safe, you tend not to worry if you’re underinsured. But if you have an unexpected setback, having the right insurance coverage can make all the difference.
Indeed, you don’t want to wait until the tide goes out to see if you have enough coverage. In part one of this two-part blog series, we’re sharing how to properly manage risk and protect your assets with life and disability insurance.
Life Insurance
Not everyone needs life insurance depending on lifestyle and other factors. However, if you do need it, it’s important to make sure you’re not underinsured.
Life insurance is an insurance policy that pays out a lump sum death benefit if the insured individual dies while the policy is active. In general, there are two types of life insurance: term and permanent.
Term life insurance remains active for a set period, typically five, 10, 20, or 30 years, so long as you pay your premiums. Permanent life insurance, on the other hand, remains active throughout your entire lifetime and accumulates cash value over time.
Who Needs Life Insurance?
In most cases, people buy life insurance to provide financially for their family in the event of their untimely death. The proceeds can then cover funeral costs and unpaid medical bills, as well as mortgage payments, education costs, and other daily living expenses.
However, life insurance is also useful if your net worth is high enough to trigger estate taxes. In 2023, the value of your estate must exceed $12.92 million to trigger the federal estate tax. Thus, many wealthy people purchase life insurance so their beneficiaries can cover this tax without dipping into their inheritance.
Lastly, if you own a business, you may also purchase life insurance to cover operating costs or outstanding debts if you pass away prematurely. Alternatively, if you have more than one child but only plan to pass the business on to one of them, you can use life insurance to provide a cash inheritance of equal value for the others.
How Much Does It Cost?
In general, permanent life insurance is more expensive than term life, given that it covers you indefinitely. From there, the primary variables that determine cost are mortality, interest, and expenses.
Mortality considers age, gender, health, and other lifestyle factors to estimate how long a policyholder will live. Meanwhile, interest and expenses relate to the insurance company itself. They reflect how much the company can earn by investing policy premiums and how much it costs them to administer coverage.
In most cases, age tends to be the primary determinant of cost when it comes to life insurance. For a 40-year-old buying a 20-year, $500,000 term life policy—the most common term length and amount sold—the average cost is $26/month, according to data from Quotacy.
However, the type of policy and coverage amount you select also affect the cost. Your occupation, driving record, and medical history may also impact your premiums.
How Much Life Insurance Do You Need to Avoid Being Underinsured?
The amount of life insurance coverage you need depends on several factors.
For example, if you have a young family, you’ll want to consider your current and future income, lifestyle, debt obligations, and other projected expenses. You may also want to consider funeral costs and potential inheritance taxes.
Ultimately, you should aim for a policy that covers your beneficiaries’ financial obligations resulting from your death.
For providers, this may be enough to pay your family’s living expenses until your children reach a certain age. Meanwhile, business owners may take out enough life insurance to cover their debts and payroll until a successor takes over.
There are a multitude of online calculators you can use to calculate how much life insurance coverage you need. You can also work with a financial planner or insurance specialist to make sure you’re not underinsured.
Disability Insurance
According to the Social Security Administration, one in four adults will become disabled at some point before reaching retirement age. If you suffer an injury or temporary incapacity that prevents you from working, disability insurance can mitigate financial costs in the interim.
Typically, disability insurance provides a monthly benefit to replace some or all of your lost income. However, the benefit varies depending on many factors, including whether you have short-term or long-term coverage.
To avoid being underinsured, it’s important to purchase the right type and amount of disability insurance.
Who Needs Disability Insurance?
Disability insurance can benefit anyone who relies on their income to support themselves and/or their family. This may include employed and self-employed individuals, business owners, and professionals in high-paying jobs.
In many cases, employers provide disability insurance as part of their employee benefits package. According to a recent survey by the International Foundation of Employee Benefits Plans, 78% of employers offer short-term benefits to their employees, while 63% offer long-term disability benefits.
Meanwhile, less than 40% of workers take advantage of their disability benefits, according to the same survey. That means more than half of employees with this benefit are likely underinsured.
On the other hand, self-employed individuals and business owners may need to purchase individual disability insurance. This is especially important if your income depends on you being present and active in daily business operations.
How Much Does Disability Insurance Cost?
In general, the type of contract you purchase, waiting period, benefit amount, benefit period, and your current health and medical history determine the cost of disability insurance. You can lower the cost by electing a longer waiting period until benefits begin and/or electing a shorter benefit period—however, this may result in you being underinsured.
A common rule of thumb is to expect to pay between 1-3% of your annual salary for a disability policy. If you pay for an individual plan, the benefit generally isn’t taxable. However, if your employer pays your premiums, you must pay taxes on any benefits you collect.
How Much Disability Insurance Do You Need to Avoid Being Underinsured?
Generally, you should aim for a disability policy that covers 60-80% of your monthly income.
A short-term policy will generally cover you for up to a year. Meanwhile, a long-term policy can range from two years until retirement.
Keep in mind you can also apply for Social Security disability benefits if you’re underinsured. However, these payments tend to be modest compared to private disability insurance.
For reference, at the beginning of 2019, Social Security paid an average monthly disability benefit of about $1,234 to all disabled workers—barely enough to keep a beneficiary above the 2018 poverty level.
In addition, it’s very difficult to qualify for Social Security disability benefits. Thus, most workers can benefit from having some type of disability insurance.
Next: Are You Underinsured Part 2: Umbrella and Long-Term Care Insurance
Indeed, there are many different types of insurance that can protect you and your assets. In this article, we described the benefits of life and disability insurance and how much you need to avoid being underinsured.
Part two of this blog series will discuss how to determine if you need umbrella and/or long-term care insurance and if so, how much. In the meantime, you may want to consider working with a financial planner who can help you determine your insurance and other asset protection needs.
Milestone Asset Management Group’s team of financial planners, CPAs, and estate planning attorneys can help you develop a long-term plan for your money, including strategies to protect and preserve your wealth long-term. To see if we may be a good fit for your planning needs, please schedule an introductory phone call.
