When buying life insurance, how do you know how much is enough?
Is it a decision based on how much you can afford to spend? Or is it based on a nice round figure like one or two million Rand?
Either way, how do you know whether one, two, or even ten million Rand life insurance is enough?
Let us start off by considering the reasons why anyone needs life insurance in the first place:
Settle Your Debt
This is the first place to start when calculating how much life insurance you need, and the obvious reason for most people looking to make a purchasing decision.
The problem with having debt is that at some point it needs to be repaid. And while you can budget to repay something like a home loan over the next 20 years, when it comes to dying it’s a different matter entirely. Your bank will insist that the debt be repaid immediately or your lovely home ends up at an auction.
Step one is to add up every cent you owe to anyone right at this moment. Think of your mortgage, cars, and short-term loans.
Estate Duty (Death Taxes)
Any assets left to anyone other than someone who meets the definition of a spouse will attract Estate Duty once the value of that asset exceeds R3,5 million.
If your assets are all left to your spouse or where the assets being left is below this R3,5 million mark, then you can ignore this expense completely. If this isn’t the case, we’d suggest you have an Estate Plan drawn up by a Financial Advisor to determine this expense.
A hidden expense overlooked is the Executor’s fees. Basically, this is the fee charged by a qualified person such as an Attorney to pay off your debts, liquidate your assets if need be, and distribute them to your heirs.
Let’s say, for example, you leave all your assets to your spouse to the value of R3 million. While there will not be any Estate Duty payable, it will still attract Executor’s fees where an executor is appointed. Currently, those fees are limited to a maximum of 3,50% of the gross estate excluding VAT.
R5 million multiplied by 3,50% means an unexpected expense of R105 000. With no life insurance in place for this hidden expense, assets will need to be sold to cover it. Make sure that you factor this expense in when determining how much life cover you need.
Bridging Finance For The Surviving Spouse
Imagine for a moment that you live in a two-income household. If one of those incomes were to fall away would it create financial stress? Winding up your estate could take two years or more. If there isn’t sufficient liquidity in the estate, you could find that homes are sold from under the feet of your loved ones. All sorts of unexpected expenses such as moving homes might arise.
A solution to much of the stress would be to provide six months’ worth of income for a spouse to bridge the adjustment period lying ahead of them. Life insurance is the perfect solution.
The Cost Of Future Education Needs
No-one will ever care about your children more than you will. Education is the key that opens doors to them living their best life. To calculate how much life insurance you will need in order to pay for this (if you are no longer around to provide for your family) the first step is finding the answer to three questions:
- How much does tuition, schooling, books, uniforms and sports cost you each year?
- How many years of schooling still lie ahead for your child?
- By what percentage do those costs increase by every year?
Now you need to project that annual cost ahead for the number of years based on the cost increasing every year.
Providing Income For Dependents
There are two schools of thought when it comes to this. The one idea is to provide the surviving spouse with a replacement of your lifelong income, while the other ideal focuses on replacing your income for a fixed number of years or until the youngest child leaves home.
· The first step is to study your net salary amount after all deductions have come off.
· Thereafter, you need to look at the monthly expenses which will fall away since you’ve already provided for them in the calculations above.
· Deduct these expenses from your net salary and you should have the monthly amount needed by your spouse
Now decide on the number of years that your spouse will require the income. It could be until your youngest child turns 21 or it could be until your spouse turns 80.
On top of that, we need to factor in inflation. R5 000 a month today won’t mean much to your spouse 20 years from now, so you want that income to increase every year by anywhere between 5% and 10%.
One way to do all of this is to project the annual income forward for the appropriate number of years all the while with a 5% or 10% increase worked in. Now you will know how much life insurance is needed to replace your income. Let’s call this their future earnings.
In order to accurately work out how much life cover you really need, you need a financial calculator or a qualified Financial Advisor to assist you.
Until next time.
The Wise About Life Team