How Much Life Insurance Do I Need?
The Role Life Insurance Plays in Your Finances The purpose of life insurance is to...
We want to be transparent about how we are compensated. Some links in articles are from our sponsors. Learn more about how we make money.
One Surprising Problem
The main problem with capitalism as practiced in the US is that it doesn’t do a great job taking care of the poor. Whether they’re poor due to mental health issues, lack of education, catastrophic health expenses, lack of opportunity, or just bad luck, our social safety nets are, shall we say (understatement warning…), somewhat lacking in taking care of them. The less-well-known problem hits people on the higher end of financial success — not knowing when enough is enough.
This raises the question — how do you know when you have enough? You can always aspire to more. If you’re like most of us, you can struggle to make your first million (it’s mathematically easy to prove that’s the hardest one, by the way). If you’ve reached that milestone, you can work on your second, third, fourth, tenth, or hundredth million. At some point, making that next buck makes no appreciable difference in anything you (should) care about.
After thinking about it for a while, here’s how I define when enough will be enough for me: it’ll be when I can live on what I’ve accumulated, no matter how long my retirement is, without eating into the principal. This is what’s also known as the FIRE point, for Financial Freedom, Retire Early (though in any particular person’s case, it may not be all that early).
Why I want to leave all that principal when I die is the subject of a different discussion, but for now, let’s take it as a given.
Here’s my simple, step-by-step guide on calculating the above point in actual dollars:
Even if you know what you spend these days, figuring out accurately how that will change over the years and decades until you retire is not simple. Some spending categories such as travel, entertainment, and gifts will go up. Others, such as contributing to grandkids’ college funds will get added. Yet others such as gas and car maintenance will likely decrease. Finally, some, such as mortgage payments, may disappear altogether (assuming you pay off the mortgage by then). With so many unknowns, the simplest way to estimate your retirement budget is to take 100% of your current net income, and subtract what you set aside for savings. For example, if your income is $75,000 and you invest 20% of that or $15,000 (way to go!), your guesstimated total retirement budget would be $60,000.
Any income you expect to get in retirement that doesn’t come from your portfolio means that you don’t need to set aside as much. Some examples include annuities (if you bought any, I haven’t), pensions (if you’re lucky enough to have one of those, I’m not), Social Security (not yet, but someday), rent from properties (minus the expense of owning them), royalties (none of those here), etc.
Let’s say you don’t have any annuities, pensions, or royalties. Let’s further say you have a rental property that you expect will bring in a net positive cash-flow of $6000 each year, and that you expect to get $25,000 from Social Security. I’d reduce that last by 20% since that’s the size cut that will be needed by 2035 if Congress doesn’t do anything, so make Social Security $20,000.
Subtract from the $60,000 example we got at the end of Step 1 the $6000 net rental cashflow and $20,000 reduced Social Security benefit, and we reach $34,000.
Essentially, you need to estimate what your pre-tax total income needs to be, given that it will likely come from dividends, selling some bonds and/or shares of stocks, and Social Security benefits, to cover your budget with a bit of margin.
The exact amount will depend on where you live in retirement, and your personal mix of income sources in retirement. For our example here, let’s assume your overall tax burden will be 20% to get you to the $60,000 you’ll need. Divide the $60,000 by 0.8 and subtract out that $60,000 ($60,000/0.8 – $60,000 = $15,000), and you get an estimated total tax burden of $15,000. Add this to the $34,000 from Step 2, for a total pre-tax $49,000 that will need to be covered by your portfolio.
Using the well-known 4% rule, you need to divide the $49,000 by 0.04 or equivalently, multiply by 25, bringing us to $1,225,000. If the above numbers and assumptions were all true and accurate for you, once your portfolio hits $1,225,000, that should be your personal “enough” point.
Then, “all” you need to do is set aside and invest enough each year to get to that point (hey, I said it’s simple, not easy ????). Oh, and I’d also suggest you create a backup plan for making a bit of money in retirement just in case your investments underperform to the point that they don’t make 4% above inflation.
Needless to say, working as an employee makes the above difficult, requiring life-long discipline, hard work, and frugality. Becoming successfully self-employed makes it far easier (though still not quite easy).
What’s your definition of your “enough” point? Have you set out your strategy to reach it?
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.