How Much Do I Need to Retire?

MONEY TALKS – Friends and family often ask me how much savings they need in order to retire. While I am more than happy to talk in generalities, I try to steer away from giving any specifics when I don’t have all the facts. Without a complete view of their financial picture, it would not only be impossible but irresponsible of me to answer their questions.

Unfortunately, more often than not, before I have a chance to respond, they hastily begin shouting out numbers. “Do I need ½ million? 1 million?” Typically this leads to me awkwardly trying to explain that the solution isn’t that simple and ethically I really shouldn’t answer their question. This response is usually met with a bewildered look and the inevitable “So you’re saying that’s not enough?” (Heavy sigh) At this point I coyly suggest that if they really want to know the answer they should become a client.

In an effort to provide friends and family with some guidance (and to quell the family banter), I have devised a quick back of the envelop calculation to give you a ballpark estimate of how much savings you need to retire. The calculation is rather easy to complete but does require some preliminary information before you can get started. I have included here a list of the necessary data as well as a simple worksheet that will walk you through this back of the envelope approach. Please bear in mind that this is a rudimentary calculation that won’t give you an exact figure, but it can be used as a reality check to see if you are on target to retire comfortably.

Here’s what you will need:

  • Pay statement
  • Federal and state tax returns
  • Social Security statement
  • Pension statement
  • Estimate of any other income you may receive in retirement.

In order to help illustrate the underlying methodology let’s consider the following scenario:

  • Tom (60) and Rachael (58) are married with four kids. Tom, an engineer by trade, is the primary wage earner with a gross salary of $150,000 per year. Rachael works as teacher earning $50,000 per year. Tom’s net take home pay is $3,750 and Rachel’s net take home pay is $1,250.
  • They both get paid twice per month, for a total of 24 times per year.
  • Last year they paid $18,400 in Federal taxes and $6,600 in state taxes.
  • Neither Tom nor Rachel are eligible for medical benefits through their employer after they retire. When eligible, they plan to go on Medicare and purchase a supplemental Medigap policy.
  • Tom is eligible for Social Security and expects his annual benefit at full retirement age to be about $43,000. Rachel earnings as a teacher do not qualify for Social Security benefits; however, through her teachers union, she is entitled to a pension benefit of $40,000 per year. Neither plan to seek part-time employment in retirement.
  • Tom and Racheal both plan to work until their mid-sixties. They live a healthy lifestyle and plan to live well into their nineties.

Now let’s work through the numbers:

retirement-chart

Based on the chart above, Tom and Rachel would need about $1.5 million in order to retire.

While I hope that you find the above exercise helpful, please keep in mind that is a static calculation which doesn’t take into account life changes that may occur in retirement. To get a more precise calculation or recommendation, I would encourage you to reach out to a qualified financial advisor.


*Multiplier is based on a success rate of 90% or more for a 15, 30, and 45 year portfolio. The calculations were completed by William P. Bengen, CFP® and can be found is his book Conserving Client Portfolios During Retirement.

** Note: the Savings Required field is not specific in nature and does not take into account your individual facts and circumstances. Accordingly, this should not be relied upon when determining how much money you need to retire, nor does it substitute for any legal, financial, tax, or accounting advice.

Business Matters

Recently, Lakeside Financial Planning was fortunate enough to be featured on Business Matters, a local cable television show showcasing premier businesses in Middlesex County. To view Lakeside’s segment please fast-forward to the 12:44 minute mark. Many thanks to the Middlesex West Chamber of Commerce along with Marc Duci and his team at Acton TV. Without their knowledge and support this would not have been possible.

A Beginners Guide to Maximizing Your 401(k) Plan

MONEY TALKS – In today’s workplace environment, unless you are working as a teacher, police officer, firefighter, or state/federal employee, the chances are you do not have a pension plan. In other words, when it comes to funding your retirement YOYO (you’re on your own). For most private sector employees, defined contribution (DC) retirement plans are their primary savings vehicle. DC plans are a type of retirement plan where an employer and/or employee make regular contributions. They differ from a pension plan in that there is no guaranteed income stream at retirement. Instead, both the employer and employee contributions, plus any investment earnings, grow together in an account where the employee has control over the cash distributions during their retirement. The most common DC plan is the 401(k) plan which has grown to become America’s de facto retirement savings plan since its inception in the late 1970’s.

A 401(k) plan is a great savings vehicle for a number of reasons. First and foremost any contributions made by the employee are tax deductible. Secondly, any earnings in the account grow tax free until they are withdrawn. Unfortunately many Americans are not taking full advantage of the benefits a 401(k) plan has to offer. There are two primary culprits behind this underutilization; lack of participation and low contribution rates. In order to ensure you are getting the most out of your 401(k) plan, make sure to follow these guidelines.

Start Contributing Early
During your first week of work you will likely be given a large packet of information listing everything from your vacation accrual to your medical benefits. Included in this packet should be an enrollment form for your employer’s 401(k) plan. You should sign up for your 401(k) plan immediately. Some employers may have restrictions on when you can start contributing or an elimination period before the employer themselves match any contributions; however, these restrictions typically do not prevent you from enrolling in the plan.

If you have already been working but have yet to sign up, there is no time like the present. To borrow a line from a colleague of mine, “You will never be younger than you are today.” When it comes to investing, the longer the time horizon, the greater the growth potential.

Maximize Your Employer Match
Most employers will make a modest contribution to your 401(k) plan presuming you do one thing; contribute to the plan yourself. While there is a wide range of company match levels, a typical employer match policy might read something like this: XYZ agrees to match 50% of employee contributions for the first 6%-of-salary that an employee contributes. In this scenario, in order for an employee to maximize their employer match, they would need to contribute 6% or more of their salary into their 401(k) plan. Any contribution below 6% means the employer is not obligated to contribute the full match.

Maximizing your employer match is critical to building your retirement nest egg. Not contributing or under contributing to your own plan means you are essentially throwing money out the window. An employer match is a guaranteed return on investment which is rare if not impossible to find in this day and age.

Take It to the Limit
The most common way to contribute to a 401(k) plan is through automatic payroll deductions. Many plans allow you to designate a percentage of your gross income to be allocated to your 401(k) plan. A good rule of thumb is to contribute 10% or more of your salary into your 401(k) plan. Unfortunately, for many young or underpaid employees this figure is simply unrealistic. For those who can’t save 10% or more, start off by saving the minimum allowable contribution that enables you to maximize your employer match. Most employer plans require employee contributions between 4% and 8% to receive the maximum match.

Automatic contribution increases are another great way to get the most of your 401(k) plan. As the name infers, an automatic contribution increase is simply an election you make to annually increase your contribution percentage (typically by 1%). The beauty of this election is it forces you to save more each year and they typically coincide with a merit increase so the effects are negligible. If your company doesn’t offer this election then remember to manually adjust your contribution percentage each time you get a raise.

Keep in mind that the Internal Revenue Service regulates how much an employee can contribute to their 401(k) plan. In 2016 the contribution limit is $18,000. If you are lucky enough to be age 50 or older, the IRS has a special “catch-up” provision which allows you to contribute an additional $6,000 for a total contribution limit of $24,000.

What Makes America Great!

MONEY TALKS – Last week I spent the fourth of July holiday with family and friends up at Lake Winnipesaukee. The weather was gorgeous which naturally lead to some of my favorite summer activities; barbequing, back yard games, and boating. On Monday we took a trip to the scenic town of Meredith to shop and grab some ice cream. During our boat ride home the temperature finally began to drop, the winds calmed, and as the boats steadily returned to their docks the water transformed to its natural glass like state. As nightfall set in I gazed across the water and smiled. The hustle and bustle was behind us and a feeling of deep relaxation had set in. Before long the fireworks were bursting and I began to reflect and appreciate some of the things that make America great. Here is a quick list of 50 things that make me smile.

  1. Football
  2. Hot dogs
  3. Pool parties
  4. Iced coffee
  5. Corn-on-the-cobb
  6. Amusement parks
  7. Lobster rolls
  8. Marshmallows
  9. Cable TV
  10. 30 Year fixed mortgages
  11. Tattoos
  12. Hamburgers
  13. Disney World
  14. Drive-in movie theaters
  15. Arcades
  16. Denim blue jeans
  17. S. stock market
  18. BBQ chicken
  19. Roof decks
  20. Pick-up trucks
  21. Farm stands
  22. Hiking
  23. Outdoor concerts
  24. Mutual funds
  25. Outdoor dining
  26. Ice cream
  27. Tax advantaged retirement plans
  28. Tailgating
  29. Waterslides
  30. Baseball hats
  31. Camp fires
  32. Corn-hole
  33. Fenway Park
  34. Harley Davidson motorcycles
  35. Government backed loans
  36. Steak kabobs
  37. Horse shoes
  38. Kites
  39. Balloons
  40. Country music
  41. Penny candy
  42. Pizza
  43. Fireworks
  44. Exchange traded funds
  45. Frisbees
  46. Sunroofs
  47. Gas grills
  48. Free trading
  49. Sidewalk chalk
  50. Sand castles

I encourage you to take the time out of your busy lives to reflect on all that is important to you. Spend less time working and more time with family and friends. Appreciate what you already have and make plans to do something you have always wanted to do but haven’t done yet. Challenge yourself to try something new and don’t be afraid to stop along the road to simply enjoy the little things in life.

10 Habits of the Healthy, Wealthy, & Wise

MONEY TALKS

1. Save – Saving more than you spend is a key concept to accumulating wealth. The extra money saved can then be invested to grow and compound over the years. Given enough time, your investment earnings may one day actually exceed the money you are saving!

2. Build a Reserve – Establishing a cash reserve or long term savings account can give you the security you need in the event of an emergency. Having liquid funds available may allow you to weather the storm without having to deplete other investments that are subject to market conditions.

3. Organize Spending – Creating separate bank accounts for your personal spending, household bills, and long term savings can go a long way towards balancing your budget. Start by funding your household checking with enough money to pay your monthly bills. Next, create a dedicated savings account funded based on a percentage of your income, say five or ten percent. The remaining money should be deposited into your personal checking and can be used for whatever you desire.

4. Buy Used Things – No one thinks twice about buying a “used” home; however, when it comes to buying a car, furniture, or children’s toy, the concept suddenly becomes taboo. Before making your next large purchase consider what alternatives exist in the secondary market. You may walk away with a lot more than you think along with some extra change in your pocket.

5. Don’t Procrastinate – Not paying your bills on time can lead to late fees and interest penalties. Over time these can accumulate to the point where the majority of your payment is going towards interest and penalties rather than paying down principal. Avoid getting stuck in this rut by paying your bills on time and in full.

6. Ditch Bad Habits – Daily stops for coffee and weekday lunches out with your colleagues can accumulate into some serious spending over time. Drinking your employer provided coffee and bringing last night’s leftover dinner for lunch are easy alternatives to help curb those bad habits. Don’t be afraid of treating yourself to the occasional iced coffee or Friday lunch to celebrate your accomplishments.

7. Know Your Limits – Most investors lose money because they overestimate their risk tolerance. When the market goes down they panic, sell their holdings, and suffer catastrophic losses. Choosing a more conservative portfolio and staying the course will get you far ahead of the typical investor who changes direction based on current market conditions.

8. Eat Healthy – Small changes can make a big difference in your overall health. Drinking water instead of sugary drinks is a great way to cut calories and reduce your sugar intake. Adding color to your meal is an easy way to improve your plate appearance and get more essential vitamins, minerals, and fibers into your body. Choose red, orange, and dark green fruits and vegetables when preparing dishes.

9. Exercise – Heart disease has risen to become the leading cause of death in the United States. Regular exercise can help combat disease and prevent a wide range of health problems. Not to mention, exercise and physical activity can also help you to maintain weight loss, improve your mood, boost your energy, and promote better sleep.

10. Wear Your Seat Belt – Each year about 33,000 people are killed in motor vehicle crashes. Tragically many of these fatalities could have been prevented. Seat belt use is the most effective way to save lives and reduce injuries in motor vehicle crashes. Make sure that you and your passengers buckle up every time you get into a vehicle no matter how short the trip.

Why You Need an Estate Plan

MONEY TALKS – There are three common misperceptions in our society regarding the need for an estate plan. A general failure to understand what an estate plan can do for you while you are still living; believing you are not wealthy enough to need an estate plan; and the third, perhaps most prevalent misconception, is that only the elderly need an estate plan. Unfortunately, more often than not, these false impressions, along with a lack of understanding, lead many people into believing they don’t need an estate plan. In fact, according to the American Bar Association, 55% of Americans die without a will or estate plan.

Failure to Understand

Most people recognize that an estate plan allows for the transfer of property at death. However, what many fail to understand is that an estate plan also focuses on the control and decision making of your affairs while living. A comprehensive estate plan will address who will make medical decisions on your behalf if you are unable to make your own decisions. It will also allow you to name a trusted person to manage your financial affairs. These important medical and financial decisions could be temporary, such as if you were recovering from a car accident, or permanent in nature if you were to develop a life changing medical condition.

Wealth is not a Factor

Another common belief among Americans is that they are not wealthy enough to warrant an estate plan. But an estate plan isn’t all about wealth. Do you know who decides where your assets go? Who will take ownership of your house? Who will be granted guardianship of your children? Without a plan in place, you are taking the control out of your hands, leaving your loved ones to handle the burden and subjecting them to the rules of the state, even if those rules may not be aligned with your wishes. This could result in your children being cared for by someone other than who you had imagined or a lifetime of hard earned dollars going into the pocket of an estranged relative.

Age is Irrelevant

The notion that estate planning is only for the elderly is another fallacy in our society. In fact, I recently had a conversation with a woman who recalled feeling insulted when an attorney brought up the topic of estate planning. She felt that she was too young to need an estate plan, and the attorney in question must have overestimated her age. While this may seem farfetched, the numbers don’t lie; 92% of people under 35 have no will or estate plan. Unfortunately accidents happen every day, and we cannot pick or choose when they will occur. The premise behind any good estate plan is to put it in place before you need it. Unfortunately when it comes to estate planning, if you wait until you need it, then it is probably too late!

Three Core Documents

Regardless of your financial status or age, here are three core estate planning documents that every adult should have.

  • A Healthcare Proxy is a legal document that allows you to name someone you trust to make important health and medical decisions on your behalf should you become incapacitated or are unable to speak for yourself. This person, known as your “Heath Care Agent,” can be a relative, friend, co-worker, neighbor or anyone else you choose as long as they are eighteen years of age. In addition to traditional medical decisions, your Agent also makes decisions on “life-sustaining” procedures. It is important for you to communicate your wishes with your Heath Care Agent so they understand your preferences from a medical, moral, and religious stand point. A Health Insurance Portability and Accountability Act (HIPAA) Release should also be included in your estate plan either as a separate document or incorporated into your Healthcare Proxy. The HIPAA language is what authorizes your Agent access to your medical records.
  • A Durable Power of Attorney is a legal document that allows for a trusted friend or relative to make financial and business decisions for you in the event you are incapable of managing your own affairs. Your appointed Agent can then handle important matters such as paying bills, managing investments, and accessing online accounts. The DPOA is most commonly used due to incapacitation relating to old age or a medical condition such as Alzheimer’s. However, they can also be quite useful in other circumstances such as managing your affairs while you are traveling abroad.
  • The Last Will and Testament is a legal document that states your final wishes in terms of who you want to inherit your assets. This includes giving your beneficiaries anything from your home to your investments to your family heirlooms, and can even include your pets! Additionally, and often more importantly, you can name guardians for your children. A named guardian prevents your family from fighting the state (or one another) in probate court and guarantees your children are being cared for by the person(s) of your choosing.

Plan Now

Creating an estate plan now can have a tremendous impact on your own life as well as that of your family. A basic estate plan that is customized for your individual needs can be drafted by a local attorney and shouldn’t break the bank. Don’t leave your health, finances, and children in the fate of someone other than your choosing. Put a plan in place now, before it’s too late!


Need an Estate Planning Attorney?

Mention this newsletter and receive a free consultation ($125 value) and 20% off a basic estate plan package at Levine-Piro Law.* Basic estate plans include: Health Care Proxy, Living Will, HIPAA release, Durable Power of Attorney, Last Will and Testament, and final disposition instructions.*

Contact:
Levine-Piro Law, P.C.
63 Great Rd #101, Maynard, MA 01754
(978) 637-2048
www.levinepirolaw.com

*Price before discount: $900/individual; $1500/couple

Protect Your Retirement Nest Egg

MONEY TALKS – Retirement planning can be a stressful time for many baby boomers because there are so many questions that cannot be answered; how long will I live, what will my health be like in twenty years, will my spouse or I need long term care, and the elephant in the room; how much money do I need? Scientific advances in the medical community have made it not only possible but likely that a healthy retiree in their sixties could live well into their nineties. While it’s great that retirees are living longer, healthier, and more active lifestyles than ever, on the flip side of the coin, there is a vast amount of time their retirement savings must last. Pulling funds out of a portfolio for thirty plus years creates tremendous strain on the portfolio. To further compound things, factors such as the retiree’s age, withdrawal rate, and current market conditions have a paramount impact on the longevity of the portfolio. Perhaps most frightening, even a modest loss in the early stages retirement, regardless of the size of an investment portfolio, can derail an otherwise solid investment plan leaving a retiree in a precarious position.

Sequential Risk

Sequential risk is not a term that is used in everyday conversation; however, anyone who has recently retired or has retirement on the horizon should make sure they have a basic understanding of the concept. In essence, sequential risk is the notion of making withdrawals from an investment portfolio during or immediately after periods of poor performance. A retiree who begins taking withdrawals from their portfolio following a market downturn is at a much higher risk to deplete their portfolio. To demonstrate the magnitude of sequential risk let’s look at two similar scenarios with drastically different endings.

Early Retirement Losses

John & Lisa have accumulated a million dollars and decide to retire at age 65. They determine that they will need $90,000 to live on of which $25,000 will come in the form of Social Security and the remaining $65,000 will be withdrawn from their portfolio annually (adjusted for inflation). Unfortunately for John & Lisa, during the first year of their retirement the market falls and has a 20% loss. In years two through fourteen their luck changes and the market remains stable returning 7% annually. In year fifteen they are hit with even more luck as the market surges and they receive a 30% return on their investment. The good news for John & Lisa is that they’ve had a healthy and active retirement and maintained their same standard of living for the last fifteen years. The bad news is at age 81 they can no longer support themselves financially because they have less than $25,000 remaining in their portfolio. To make matters worse, the recent financial stress has caused John & Lisa’s health to take a turn for the worse and now they are considering moving into a state subsidized nursing home.

Losses Down the Road

John & Lisa’s neighbors, Bruce and Diane, have also accumulated a million dollars and decide to retire at age 65. They too will need $90,000 in living expenses and will receive $25,000 from Social Security. Fortunately for Bruce and Diane in their first year of retirement the market spikes and returns 30%. In years two through fourteen the market remains unprecedentedly stable and returns 7% annually. Unfortunately in year fifteen their string of good luck changes and the market drops 20%. Fortunately for Bruce and Diane, due to the positive early returns, their portfolio was large enough to withstand the latest market downturn. Despite losing over $229,000 in their portfolio over the last year, they still have over $900,000 dollars remaining. Like John & Lisa, Bruce and Diane have lived a healthy and active retirement. However, instead of looking for nursing homes, Bruce and Diane are looking at independent living villas in Costa Rica because the winters in Florida are just too cold for them.

Similar Story – Different Ending

While the facts remain strikingly similar, the end of their stories is vastly different. Unfortunately no one can predict what the stock market is going to do tomorrow, let alone next month, year, or ten years from now. Unless you have a flux capacitor, trying to plan your retirement date around future market forecasts is a futile and will not get you far. So what can be done to mitigate sequential risk?

Mitigate Sequential Risk

There are a multitude of different strategies that work well to help reduce the risk associated with early retirement withdrawals. However, regardless of the specific strategy chosen, they all centrally revolve around two main concepts; minimizing volatility and monitoring withdrawal rates. Strategies that focused on minimizing volatility may be a more appropriate approach as changing your withdrawal rate in retirement is not feasible for many retirees, especially for those living on a fixed income.

Ultra-Conservative Portfolio

Rather than taking a traditional approach of starting at 60% stocks (40% bonds) and reducing the weight as you age, consider taking a road less traveled. In order to minimize volatility during the onset of retirement, switch to an ultra-conservative portfolio. Dropping to a 30% stock allocation in early retirement has historically kept losses, even during the worst bear markets, to single digits. Minimizing the effects of market crashes protects your nest egg during the most critical stage of your retirement. As you get further along into retirement, gradually increase your equity exposure to as much as 60%.

Dedicated Cash Flow Stream

Another hybrid approach to minimize an early retiree’s volatility involves creating a dedicated cash flow stream to fund withdrawals. Using this approach, the amount of the withdrawal would be the same; however, a dedicated portion of the portfolio would be specifically set aside to fund the withdrawals. The simplest approach to create a dedicated cash flow stream is through the use of a laddered Certificate of Deposit. A ladder is sequential series of maturing term CD’s. For example purchasing a 12 month, 24 month, 36 month, 48 month, and 60 month CD. The maturing CD’s give a retiree a guaranteed cash flow without having to worry about current market conditions because the portion subject to withdrawals has already been prefunded and cannot lose value. The volatility in the remaining portion of their portfolio is mitigated because no funds are being withdrawn from this portion.

Fundamental Philosophy

Both approaches are based on the fundamental philosophy that an early retiree is at a greater risk from a market downturn than a mature retiree due to the number of withdrawal years. Consider reducing your sequential risk by transitioning to a more conservative portfolio at the onset of retirement or by creating a dedicated cash flow stream to eliminate or minimize early withdrawals from your portfolio.

Friendly Advice during Tax Season

MONEY TALKS – Winter is fading away, and the 2016 tax season is now upon us. Unfortunately, with the tax deadline fast approaching, many of us are feeling stressed. To help alleviate some of your stress I have put together a quick list of tax tips to help you get past the finish line. Remember to always to consult your CPA or tax advisor before implementing any tax strategies herein.

New Tax Deadline

In 2016 you will have a few extra days to complete your tax return. Federal law mandates that any holiday in the nation’s capital also applies to offices there. Due to Emancipation Day falling on April 15th, the usual due date for annual 1040 filings is pushed back to Monday, April 18th. Taxpayers in Massachusetts and Maine get an extra day because of Patriots Day. The due date for filing 2015 personal income tax returns for MA and ME residents is Tuesday, April 19th.

 Itemized Deductions

Most individuals remember to deduct the state income and real estate tax they paid; however, not everyone is aware that you can also deduct any local excise tax paid on your vehicle as long as the tax is yearly and is based on the value of the vehicle. Charitable deductions are another area that are often overlooked. Remember that the deduction is not just for cash contributions; clothing and other personal items can also be deducted. Lastly, be sure to include any fees paid to your CPA or Financial Advisor as they may be deductible.

 Retirement Contributions

Technically you can still make an Individual Retirement Account (IRA) or Roth IRA contribution for the 2015 calendar year up until April 18th of 2016. The contribution limit, although subject to Adjusted Gross Income (AGI) limitations, is up to $5,500 per person with an additional $1,000 “catch-up” contribution allowed if you are over 50 years old. If you make an IRA contribution it may be deductible on your 2015 tax return and could reduce your tax liability.

Avoid Fraudulent Schemes

The IRS does not reach out to individuals through the phone or by email, they generally send letters via snail mail. If you receive a phone call or email from someone claiming to work for the IRS, it’s probably someone trying to scam you. Do not give any personal information over the phone or email, and report the incident to the proper authorities immediately. The IRS, through their website, continues to issue warnings about tax scams, including fake IRS agent phone calls, email phishing, and other identity theft attempts by criminals.

Protect Your Personal Information

Never enter personal information through a link or an unsolicited email. Many of these links contain phishing schemes where they clone a page to look like the real site; however, it’s actually a fake site designed to steal your user credentials. Any electronic documents containing sensitive information should be password protected or encrypted before it is transmitted online. All paper documents containing confidential data should be shredded, unless they are being used to support your tax return. Supporting paperwork should be filed away in a safe and secure location.

Choose Direct Deposit for Your Tax Refund

If you are being issued a refund, a direct deposit refund into your personal bank account is the most secure method. Since your refund goes directly into your account, there’s no risk of having your refund check stolen or lost in the mail. Furthermore, direct deposit is the fastest way to get your refund. You should deposit your refund into an account in your own name. Avoid making a deposit into accounts owned by others. If you are filing a joint tax return, some banks require both spouses’ names on the account to deposit a tax refund.

How Much Life Insurance Do I Need?

How Much Do I Need?

I am frequently asked by clients, friends, and family members; how much life insurance do I need? More often than not, before I have a chance to respond, they begin telling me the balance on their mortgage, why they have so many credit cards, and the number of years remaining on their student loans. Unfortunately, while this information may be useful when creating their financial plan, it’s not relevant when determining their life insurance needs.

Debt Replacement

Most people tend to take a Debt Replacement approach when evaluating how much life insurance to buy. They simply add up all of their major debt and buy an equal amount of life insurance. For example, if your mortgage was $320,000; student loans were $35,000; and auto loans were $20,000 then you would buy $375,000 in life insurance. Since the household debt is the same for both spouses, your spouse would get a policy for the same amount. The problem with this method, while logical and easy to calculate, is it has some major shortfalls. Most notably, the Debt Replacement Method completely ignores how much income is earned and whether or not the surviving spouse can maintain their current lifestyle even if they are debt free.

Consider this scenario: Jim, a 45 year old father of three makes $150,000 a year as a software engineer. While watching the Patriots game, Tom Brady throws an ill-timed interception in the red zone. Jim clutches his chest, falls to the floor and suddenly passes away from a massive heart attack. His wife, Anna, is a stay at home mom with no earnings outside of the interest on her savings account. Jim and Anna’s household debt totaled $375,000 which also happens to be the amount of insurance each spouse has in force. Six weeks after Jim’s funeral Anna gets a check in the mail for the life insurance proceeds and immediately pays off all of their debt. An immediate sense of relief passes through her body knowing she will never have to make a mortgage payment again. Regrettably, in a fleeting moment her sense of serenity is gone and replaced by a strong feeling of anxiety.

The problem is, although Anna no longer has a mortgage payment, student loans, car payments, or consumer debt there are still other expenses she will incur to support her family needs. Real estate taxes, utilities, gas, and groceries are just a few expenses that would not be covered by the insurance proceeds. Without an income stream to support her family, Anna would be forced to sell the house just to make ends meet. Although the Debt Replacement Method makes sense logically, it is not practical when actually applied to a real life scenario.

Income Replacement – Working Spouse

The Income Replacement Method is a much more comprehensive and suitable way to determine your coverage needs. This method works well because it essentially replaces the income stream of the deceased spouse. However, it should be noted that calculating your coverage needs can be more complex using this method and should be done by a professional. The amount of coverage needed is determined by calculating a present value of your after-tax income stream from now until your projected retirement date. The reason after tax income is used rather than gross income is because life insurance proceeds are tax free. Projected retirement date is important because it generally coincides with the end of your income stream. In other words, you only want to replace the income stream until your working career ends. Expenses such as mortgages, consumer debt, and college tuition are not factored in because these expenses are usually paid out of your income. Since your earnings are being replaced, expenses can be ignored to avoid double counting your insurance needs.

Going back to our example, if we rerun our calculation based on the Jim’s age (45), projected retirement age (65), after-tax income ($105,000), and projected post-inflation return on investment (5%), the income replacement method tells us Jim would need a lump sum of 1.3 million to replace his income stream for the next 20 years. In this scenario Anna could remain in her home with the kids without having to worry about going back to work or selling the house because the household income would remain the same.

Income Replacement – Stay-At-Home Spouse

While the Income Replacement Method works well in most scenarios, it’s not without its faults. One problem with this method is, if we reverse the circumstances and assume Anna predeceases Jim, the Income Replacement Method tells us Anna doesn’t need any life insurance because there is no income to replace. In cases where one spouse doesn’t work or works part time, we need to take into account what services they provide to the household that allow the primary wage earner to continue working. Services such as cleaning, cooking, and watching the kids would have to be replaced by hiring a cook, maid, and au-pair. The cost to hire these professionals should be used when factoring how much “income” should be replaced. Don’t be surprised if the stay at home spouse needs the same or more insurance than the working spouse. According to Salary.com the value of a stay at home mom is almost $119,000 nationally!

What Does the Future Hold?

Evaluating your life insurance needs can be a tricky exercise because no one knows what the future holds. Estimating your future earning potential, retirement date, and return on investment can be a daunting task. Changing just one factor slightly can have a major effect on the results. When evaluating your needs be sure to consult with an experienced and unbiased professional before determining, “How Much Life Insurance Do I Need?”

5 New Year’s Resolutions for 2016

1. Pay off Consumer Debt

Credit cards can have interest rates well into the double digits. Paying off credit card debt is a great way to free up cash flow for the future. Credit card purchases are generally for short term items that have no lasting value. Putting away your credit cards and learning to live within your means can go a long way towards financial independence. If you are prone to consumer debt, try consolidating your credits cards down to one and using cash for everyday purchases.

2. Build an Emergency Reserve

Wage earners should have a minimum of 10% of their gross annual income in a long term savings account. An additional 20% should be saved as an emergency reserve. The best place for your emergency reserve is within your 401(k) or other tax sheltered accounts because the interest earned is tax deferred. Self-employed and retired individuals should build their cash/emergency reserves to an even greater level. As an additional test, the combined value of cash and emergency reserves should be at least 20% of your mortgage balance.

A Home Equity Line of Credit or HELOC is loan where a homeowner can borrow against the equity they have in their home. Unlike a conventional home equity loan where the borrower is advanced the entire lump sum up front, a HELOC is different in that the borrower only draws on the line of credit if needed. A HELOC could be used to cover a variety of expenses including unforeseen outlays for home improvements or medical bills. Homeowners should consider getting a HELOC as a supplement to their cash/emergency reserves as an added security blanket.

3. Purchase Long Term Disability Insurance

For most workers, the ability to earn a living is their most significant financial resource. A disabling illness or injury stops income, often leads to additional medical costs, and prevents savings for key goals such as education and retirement. Despite these facts, employees are more likely to have dental insurance than long term disability. The reason for this is most people associate disability with serious accidents. Since very few employees have high risk jobs, the general inclination in the workforce is to say, “I don’t need it” when it comes to disability insurance. In reality this couldn’t be further from the truth as 90% of disability claims are due to illness not injury. Even people who don’t have high risk jobs are still at risk of disability from cancer, cardiovascular, muscular, or other illnesses. A disabling illness or injury can have a devastating effect on you and your family. Purchase long term disability insurance now to protect you and your family’s financial security.

4. Increase Retirement Savings

Most company retirement plans allow you to enroll in a plan where your contributions are automatically deducted from your paycheck and directly deposited into the retirement plan. The beauty of automatic deductions is, since you never see the money, it’s nearly impossible for you to spend it. The only problem with this out-of-sight, out-of-mind enrollment process is most people set up a standard contribution rate when they enroll in their plan and never think to increase it. Lots of employers now offer an auto increase plan where your contribution percentage will increase by 1% per year. If your employer offers an auto increase plan be sure to enroll, if not then be sure to increase your contribution percentage manually each year. Consider investing in an Individual Retirement Account (IRA) if your employer does not offer a retirement plan.

 5. Create an Estate Plan

Approximately 55 percent of American adults do not have a will or other estate plan in place. The primary reason for this staggering statistic is twofold; one being that no one wants to think about their own demise. The other; more alarming reason, is because many Americans are ill-informed on benefits of an estate plan. The most common excuses I hear are; “I don’t have children so I don’t need an estate plan” and “estate plans are only for wealthy families.” Both of these statements couldn’t be further from the truth. Most people don’t know that one of the primary purposes of an estate plan is to give guidance while you are still living. Questions such as, whom do you want to make medical decisions on your behalf or what are your wishes concerning life-prolonging procedures are typically addressed in a comprehensive estate plan. Regardless of your wealth or family situation an estate plan is beneficial for everyone involved.