The Rule Of Thumb

Rules of thumb help guide most people in life. Whether we realize it or acknowledge it, we have rules of thumb that guide us in most things, and our financial lives are no different. There are rules of thumb that keep us on the right track for our savings, investment, and, of course, insurance. Most financial planners and insurance experts recommend that you have insurance policies in place that would payout the equivalent of ten times your annual income before taxes. So, for example, if you earned the typical American salary of $40,000 before state and federal taxes, the insurance rule of thumb says that you should have approximately $400,000 in life insurance coverage.

Why Ten Times Your Income?

The rule of thumb states that you should have about ten times your pre-tax income in life insurance. But, where did the ten times income figure come from? It primarily has to do with the stock market, believe it or not. The historical rate of return for the United States stock market has been between 8% and 10% over the course of history dating back to even before the Great Depression. That is a great long term historical track record. Those average rates of return have survived some of the most trying times for investors, through stock market crashes, recessions, and bear markets. Of course, some years are better than others, but over the long-term, the average has been almost 10% rate of return.

So, if you should die prematurely, your heir could take that lump sum payment which is almost always tax free and invest that insurance money in a broad market index fund that earns the market average rate of return. Without touching the principle investment, your heirs could live off of the interest alone. So, for example, if you earned the average American household income of $40,000 per year before taxes and bought a life insurance policy valued at ten times your annual income ($400,000), that lump sum would earn a 10% rate of return year in and year out. That payout of $40,000 (10% of $400,000) each year to your heirs would replace your income without touching the principle. The breadwinner of the family’s income has been essentially replaced by insurance. Because you are using interest earned to live off of, the heirs will owe income tax on those proceeds which is why you purchase life insurance based off of your pre-tax annual income. After paying taxes on the interest income from the insurance proceeds every year, it will replicated your take home, after tax pay very closely.