I think I understood how to almost calculate the needed insurance based on the human life method.
However, I am confused about a step. Towards the end, we estimate the amount of pre-tax income needed to replace that income on an after-tax basis by using the tax rate for life insurance proceeds.
I didn’t conceptually get the logic of this step. Why are we calculating the pre-tax income? Arent life insurance proceeds tax free?
Not necessarily. Hence, the tax rate on life insurance proceeds.
I know I am probably going to ask something stupid now, but are we adding this tax rate to calculate the amount we need for the insurance? I mean at the end the amount taxed go to the government, so why is it relevant to the calculation?
You need, let’s say, USD\ 500,000 net (after taxes) from the life insurance. If the tax rate on life insurance is 18%, then you need \frac{USD\ 500,000}{1 - 18\%} = USD\ 609,756 as the face value of the policy. You’ll receive the payout of USD\ 609,756, pay 18\% of that (= USD\ 109,756) in taxes, and be left with USD\ 500,000 net.
When I wrote paper, I was so confused about this. This is very good explanation.
You’re very kind.
Please if you have time look at exhibit 12 on page 401.
With human life value method, they use pre-tax income to find the recommended life insurance. The life insurance amount is a pre-tax amount.
But for needs based, they use after-tax amounts because of expenses and so forth. That makes sense but when the life insurance is calculated, is the amount they show, the after-tax additional life insurance amount?
In exhibit 12, is the additional life insurance amount they calculate pre-tax for the human life method and the additional life insurance amount they calculate using the needs analysis an after tax amount?
That seems weird if that’s the case. Thanks.