We have had five physicians under the age of 55 pass away in the past 12-18 months. Each owned what they thought was enough life insurance. Often, I’m asked how much life insurance is enough.
Do you own enough life insurance?
Clients buy life insurance for many reasons, to replace income, provide for dependents, to pay off tax liabilities, as a retirement and estate planning tool. To answer the question of how much is enough, let’s first focus on the primary purpose of life insurance: to provide for your family in case of premature death.
Lets pretend you are a 52-year-old Physician, earning $500,000 a year. Your home is worth $2.0M and you have a mortgage of $750,000. Your spouse is 48 and working part time in the office and your children are 8 and 14. With respect to your investments you have $750,000 in your RSP, $175,000 in RESPs and $400,000 in your corporate investments where you save $100,000 per year. Under this scenario, you are drawing out $325,000 per year before tax to live on. With respect to your insurance, you have $1M of OMA term life insurance.
Step 1: Do the math
First, examine what you spend per month and what you need to provide your spouse until he/she is ready to retire. There are a few things we need to know before we can run the numbers…
- How long do you need to provide funds to replace your missing income?
In this example, we assume your spouse needs income replacement for 20 years as by this time your youngest child is 28 and no longer at home at which time your spouse can sell the house and slow down.
- How much income do you need to replace?
In most cases, your family will need 75% of your income to live on or $245,000 (75% of $325,000) in today’s dollars assuming the mortgage is paid off.
- What is a realistic return on investment?
We assume 6.5% before fees or 5% after fees. You then need to adjust returns for inflation (2%). Therefore, a 6.5% rate of return, translates into a 3% real rate of return.
In order to provide an income of $245,000/year in real dollars (inflation protected) for 20 years earning a real rate of return of 3%, you need an asset base of $3,645,000.
Step 2: Figure out where the money will come from
Can we draw equity out of your home?
No. Your home is where your family lives. While many clients say that their spouse will sell the house, it is rarely the right solution as your family needs stability. Your spouse will most likely want to pay off the mortgage of $750,000.
Can we draw income from your registered funds?
No. Your RSP flows to the surviving spouse’s RSP tax-free and if withdrawn, it will be taxed. The RESPs provide for the children’s post-secondary education.
Can we draw income from your corporate funds?
Yes. Assuming your will is up to date and your spouse gets your shares at the time of your death, he/she will become the voting shareholder and can draw the funds out as a dividend. With 400K of investments, assuming the same 5% rate of return, over 20 years, he/she can draw out $32,097 per year for 20 years as a taxable dividend from the corporation. Assuming an income bracket of $75-85K, these dividends will be taxed at approximately 19% or the net after tax income will be $26,000/year.
What about your life insurance?
Your spouse will get $1M of OMA term insurance on your death.
- If they invest this and assume the same 5% return over 20 years, this will only provide $67,215/year before tax or $47,050 after tax.
- They will most likely want to use the $1M to pay off the mortgage of 750K.
Step 3: Review your liquid assets and financial situation.
- You need to provide a pre-tax income of $245,000 per year
- You need to provide this income for 20 years
- Your corporate investments will generate $26,000 of dividends
- Your OMA life insurance will be used to pay off the mortgage.
- You require an asset base of $4,025,000 just to replace your income for 20 years. If you wanted to provide this income for 30 years, you need an asset base of $5,062,097.
- You don’t have enough liquid assets. You need life insurance to fill the gap.
Life insurance fills the gap between your liquid investments and your families need. Having the right amount of insurance is a crucial step in building and maintaining a strong financial foundation.
When someone passes away people come and celebrate their lives. Some people bring flowers, some bring sweets, we arrive with a cheque. Our job isn’t sexy, but we make sure that the cheque is big enough to take care of your family. There have been times when we have delivered cheques and spouses say, “that’s it?” and other times they have said “wow that will really help us.” The question is how you want to be remembered.
Elliott Levine is the President of Levine Financial Group in Toronto
416-222-1311 I firstname.lastname@example.org
The above discussion was for conceptual purposes and is not to be relied upon for definitive legal, tax or financial advice. Those interested in exploring these topics should consult with the appropriate tax advisers to discuss their specific needs and circumstances. E&OE.