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How Income Replacement Works with Life Insurance

Pile of quarters, nickels, dimes, and pennies

Life insurance can be complicated. Between choosing a provider, planning a policy, and picking a payout, it’s hard to choose what’s right for you and your family. A simple way to look at your insurance is as a replacement for a loss in income. If your family loses your paycheck, how much will it take to keep them afloat? 

How Does Income Replacement Work? 

62% of people in one study say they get insurance to use as income replacement. When used as income replacement, life insurance ensures your family is financially secure no matter what happens. But how do you figure out how much money will keep them financially secure? That’s where income replacement plans come in.

How to Calculate Your Income Replacement

Income replacement calculates the value of your insurance payout based on how much you make. For instance, you might take your current salary and multiply it by the amount of years to your retirement. 

A 35 year old might make $50,000 a year and plan to retire at 65, so they might take out a policy worth $1.5 million. While that may seem like a lot, younger policyholders can get seven-figure plans for as low as $30 a month.

Depending on the kind of insurance you have, you can also change your plan as you get older.

Another way to calculate your income replacement is based on your age. Not only are you getting closer to retirement, your cost of living tends to decrease. Kids move out, you pay off your mortgage, and your overall spending decreases. For calculating your income replacement based on your age, here’s a general guide:

  • 20s–30s: Equal to 30x your gross income
  • 40s–50s: Equal to 15x–20x your gross income
  • 60s–70s: Equal to 5x–10x your gross income

Both of these methods are very simple ways of looking at income replacement, based only on your salary, age, and working years left until retirement. 

However, you may choose to also factor in other details:

  • Inflation
  • Wage increases
  • Loss of health insurance
  • Household spending
  • Final expenses (e.g., burial and medical costs)

To get a clearer understanding of what your family might need, try an online income replacement calculator or consulting with a financial advisor.

Finally, make sure to take a look at any outstanding credit card debt, loans, and other financial obligations before choosing a policy.

Do I Need Life Insurance If I Have No Debt?

There are two main things to keep in mind when choosing your policy’s final payout: your current income and your debt. 

While you want to make sure your policy replaces lost income, it’s also important that the payout addresses any existing debts. Not all of the deceased debts need to be paid by their beneficiaries, but if they co-sign a loan (or the spouses live in a community property state) they can be held liable.

Even if you’re out of the red, make sure you plan for future costs. These could be anything from mortgage payments to a child’s college costs. 

But you probably don’t need to invest in an expensive insurance policy if you fit into all three of these circumstances:

  1. If you have no financial obligations
  2. If you have plenty of savings tucked away 
  3. If you have little to no credit card debt

When Can I Use Income Replacement?

Though many people get income replacement plans to leave to beneficiaries, some policies can be used by living policyholders.

Both employers and private providers can offer disability income replacement. Many employers offer long-term sick leave to help employees for years after they’ve been diagnosed. Some even provide assistance until retirement age or for a person’s entire life. 

A private disability income policy can also replace income. Though most plans will only replace part of your income (50%–70%), these benefits will not be taxed. 

Income replacement can also be used by retired policyholders. Even if you’re still young, it’s a good idea to invest in retirement insurance. You can dip into these policies once you turn 60 or 65, at the end of your working career. 

If you don’t put away enough in a saving account, an annuity policy can provide another source of revenue.

How Does an Annuity Work?

An annuity is a contract that allows you to receive payments from your insurance company. By paying an extra premium, you essentially set aside a guaranteed savings account for yourself. If you outlive your savings, an annuity makes sure you still have funds. 

Is an Annuity a Good Replacement for a Pension?

While an annuity works like a pension, it is not the same thing. While a pension is provided by an employer or the government, an annuity is a product you buy. While you might buy an annuity to add on to a pension, it is not a replacement and its cost will usually outweigh the final payout. 

Think of it like buying a savings plan, not an investment.

How Does Life Insurance Create an Immediate Estate?

An estate is essentially a person’s net worth. If you take out a life insurance policy, you create an immediate estate once you pass away. Even if you have $0 in the bank, your beneficiaries are still left a lump sum through your insurance. 

Some people might worry that with the creation of an estate, their beneficiaries may have to pay estate taxes. However, these really only apply when the assets are worth millions. Most policyholders won’t need to pay estate taxes.

What Are the Trade-Offs of Income Replacement? 

With any financial product, there’s a trade-off. 

Unlike a regular savings plan, income replacement limits access to your money. This lack of access is fine if you’re leaving all your money to your beneficiaries, but it can be a problem if you need that money while you’re still alive.

While living policyholders may be able to access their money, most can only get money under certain conditions: once they reach a certain age, if they have severe health problems, or if they have a disability. Even these workarounds may require additional fees, extra policies, rider add-ons, or loans. 

However, income replacement insurance is just one of the ways to determine how much insurance you should get.

What Other Options Are There Besides Income Replacement?

There are plenty of alternatives to income replacement insurance. 

Early retirement medical insurance, supplemental medicaid insurance, and long-term care insurance are great if you’re looking to cover living medical costs and fees. 

Most types of life insurance plans can also add living benefits, critical illness, or disability clauses. These riders allow policyholders to use part or all of their policy’s payout if their health prevents them from working.

For retirees, a 401(k) and Social Security are both common alternatives to income replacement insurance. Access to either is limited by your age, and your SS will be calculated on how much you earn in the last 5 years of your career. 

Insurance allows you a bit more access to funds before retirement. A plan can offer living benefits or provide direct funds through cash value loans, investment vehicles, or insurance settlements. 

If you’re looking to diversify your retirement savings, plan for your beneficiaries, or create an alternative source of revenue, don’t limit yourself to just one option. Look into creating multiple income streams from a 401(k), social security benefits, work pensions, and yes, different types of insurance. 

Compare policies and see how affordable life insurance can help ensure financial security for you and your family.


Key Takeaways

  • Income replacement calculates the value of your insurance payout based on how much you make.
  • If you don’t put away enough in a saving account, an annuity policy can provide another source of revenue.
  • Insurance allows you a bit more access to funds before retirement.

Blog Finance How Income Replacement Works with Life Insurance

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