What is your most important asset? When asked this question, most people respond with their house, their 401(k), or the inheritance they hope to receive from their rich relative. Rarely do people say their income; however, for most people their greatest asset is their ability to earn an income. The ability to earn an income is one of the primary factors influencing your lifestyle and the amount of money that is saved or invested in retirement accounts. However, despite its importance, many people do not adequately protect this valuable asset.
One way to protect this asset is with life insurance. While most people are familiar with life insurance, often via their employer, many are under-insured. The “correct” amount and type of insurance varies by individual and family, but there are a few rules that can be applied to estimate an appropriate amount of life insurance.
A three-pronged approach to determining the appropriate amount of life insurance can both highlight the significance of your income and protect against being over-insured or under-insured. One approach is simply a five to 10 multiple of your salary. A second approach is to multiply your current salary by the number of years until you retire. This number reflects your future earnings and the income that would be lost should you die today. Clearly, accounting for expected future pay increases should also be considered. A third approach is to determine the amount of money, that when invested at a conservative rate of return (say five percent), would generate the income earned by the recently deceased. Averaging these three approaches results in an amount of life insurance coverage that could be sufficient to replace income lost by a premature death in the family.
A second way to protect your income is with disability insurance. Life insurance can be an easier concept to understand than disability insurance coverage because there is a 100 percent chance of death, but less than 100 percent chance of disability. While the risk of disability is less than 100 percent, there is considerable risk in not protecting your family’s finances against the possibility of your disability and thus resulting in an inability to earn your income. Most people who have disability insurance have it via their employer. While this coverage is preferable to no coverage, know that this coverage ceases to be in place should you leave your employer.
The maximum disability insurance that you could receive is equal to about 60-70 percent of your salary. While not a complete replacement of your income, 60-70 percent of your income is better than zero percent of your income.
Finally, be aware that if you pay the premiums on your disability insurance policy with after-tax dollars, the income you receive from that policy will usually be exempt from income taxes. However, if your employer pays the premium and/or you use pre-tax dollars to pay the premium, the income you received from that policy will usually be subject to income taxes. Who and how the premiums are paid is an important factor when considering the net amount of income you would receive from the policy.
Regardless if you correctly identified your greatest asset as your ability to earn an income, these steps can help you move toward adequately protecting this asset. Much like reviewing your investment portfolio on a regular basis, it is important to review your life insurance and disability insurance coverage regularly.
FPA member Kevin Moore, CFP®, AIF®, is a principal at i*financial. Securities and advisory services offered through Commonwealth Financial Network®, member FINRA/SIPC, a registered investment adviser. Fixed insurance products and services offered by i*financial are separate and unrelated to Commonwealth. Strictly intended for individuals in: CA, CO, CT, DC, LA, MD, MN, NC, OK, OR, TX, VA, WA, WI. No offers may be made or accepted from any resident outside these states due to various state and registration requirements regarding investment products and services.