Calculating Capital Needs At Death
A Capital Needs Analysis (CAN) determines how much capital is needed to provide for survivors at the death of a breadwinner. I said “a” and not “the” because today, it is more likely to have two breadwinners in a family than it is to have just one.
Let’s look at John and Mary (which could also be John or Mary). They are 35-years old, have to children and each earns $40,000 per year. They pay $14,000 in taxes, live on $60,000 and save $6,000. What if one of them dies? Their income is lost and must be replaced. A CAN calculates how much money a capital (lump) sum needs in order to provide for the survivors.
The starting point for preparing a CAN is cash flow. In the above example John and Mary each earned $40,000. It would be inaccurate to say that there is a need to replace $40,000 of income should one of them die. It would probably be less: here’s why.
A cash flow should show income from all sources: salaries, investment income, alimony and whatever else brings it in. The next part would show living expenses such as food, shelter, clothing, entertainment and insurance. Be honest. Do not overlook anything., Next, calculate your taxes and be sure to include your retirement plan contributions, such as 40l(k) and IRA’s, as these are usually tax-deductible.
Now that you have prepared a cash flow, you can analyze it to see what each breadwinner’s contributions and expenses are. With the numbers spread out, you can see what has to be re-placed when John or Mary dies. Gen-erally, the whole salary need not be replaced because part of the salary goes to taxes. And don’t forget the upside of death: the deceased no longer generates expenses.
After careful analysis of an accurate cash flow, we have divined that if John or Mary should die, the family will need additional income of $30,000 per year. Next, we need to perform a capital needs analysis to determine from where the annual $30,000 will come.
Step one of the CAN is to determine how much capital is available at the death of John and Mary. We guys g first (but you women are catching up with stress in the workplace and such) so let’s look at what would happen were John to die.
John owns half of the equity in the house, but that does not produce in-come so we won’t count that. He also has a 401(k) account but we don’t want to count that because it serves better as a retirement asset for Mary. If it is used at John’s death, then all taxes become payable immediately, so let’s save it for Mary’s retirement. She will not pay any taxes on the transfer because only a spouse can treat an inherited qualified plan as their own.
John also had some stocks worth $20,000 as well as group term life in-surance from his employer of two times salary or $80,000, giving him $100,000 of capital at death.
One way to calculate what is needed is to use an “interest only” assumption. Interest only means that I will take only the earnings from an investment portfolio, leaving the principal intact.
For example, if I need to replace lost income of $30,000, I would need $500,000 in a capital account if I were to assume a conservative rate of return of 6 percent ($500,000 x .06 = $30,000.) The error of using interest only is, if I rake out only the earnings, the money will last forever. Inflation offsets this “error”.
If I were to assume zero inflation, $500,000 would produce $30,000 of income annually, forever. However, since inflation is not likely to be 0%, my “error” in using interest only is offset by inflation.
Here are some examples: Using the current inflation rate of 3% and, as-suming the investments earn 6%, if I withdraw 6%, the money will last for 16 years before inflation erodes the principal. Alternatively, if my earnings are 10%, which is not difficult using a balanced portfolio of stocks, bonds and cash, and I withdraw 6%, the money will last 45 years. By then, the kids should be grown and emancipated.
Wait a minute: We calculated John’s needs to be $500,000. But he has $100,000.
What about the missing $400,000? Life insurance, the instant estate build-er is the answer. John needs an additional $400,000 of life insurance.
What kind of life insurance? There are two kinds of life insurance, term and permanent. Permanent life insurance costs more because you keep paying until you die, which is late 70s for men and early 80s for women.
Term insurance is dirt-cheap when you are young (like John and Mary) and very expensive when you are old. Since survivor needs are temporary (except in the case of special-needs children) term policies are the ticket for John and Mary.
They could each purchase $400,000 of 20-year level term insurance for approximately $360 annually which would take care of the surviving spouse and children in case of the premature death of either.