The ins and outs of income replacement

Personal finances come with no shortage of responsibilities. We have to manage our investments, debts, budget, and even taxes. Of course, the common link in all of these is money. This extensive list fails to include the major task of managing income, AKA the source of our money.

Income management is about how to protect it from life's uncertainties. What if you couldn't work for a long period of time? Or, what would happen to all your carefully laid out financial plans if your family was suddenly stripped of one of its main income providers? Income management answers these questions with a simple, two-word response: income replacement.

What is income replacement?

To put it straight, income replacement is the term used to describe a plan, often in the form of an insurance policy, that aims to replace part or the entirety of your income if you or your dependents couldn't count on it anymore. Whew — that was a mouthful. Let's take a look at the elements that make up income replacement:

1. The income: You should determine how much money you need to replace your income over the period of time you want it to be replaced.

2. The insurance: What policy do you want to take out to replace your income? It can be in the form of disability insurance, critical illness insurance, or life insurance. We will be focusing on life insurance here since it's the simplest and cheapest.

3. The dependents: Anyone who financially depends on you is considered your dependents. It could be your partner, your parents, or your siblings, but in most cases, your children are your main dependents. This means they rely on your income for basically everything.

In short, income replacement means having a financial plan for your dependents using an insurance policy.

Why is income replacement important for your family?

Take a look at your family's budget. You will quickly realize that your personal expenses, like your daily coffee or your monthly public transportation pass, are only a small part of it. Most of your income is probably used on "family expenses," such as groceries, electricity and internet bills, taxes, and apartment/mortgage payments. If you have children, you’ll have additional expenses for their activities and — let's not forget the elephant in the room —  school fees. After all is said and done, you still need some leftovers to save up for retirement.

Now, review that same budget but this time, take away your own or your partner's income and personal expenses. You’ll realize the colossal impact of the missing income, and have a better idea of how important income replacement is. And we’re only taking a look at one year’s worth of missing income; the same "hole" has to be filled the year after, then the next, and so on until your dependents are no longer dependent on your income.

This is why income replacement is so important: With it, you are effectively protecting your family's future.

What are my options for income replacement?

If it's such a big deal, then why isn't the government doing anything to help? Well, it is!

Canada Pension Plan includes a monthly benefit of $257.80 for children under 25 who’ve lost a contributor (i.e. a parent). In Quebec, the equivalent is available via the QPP's orphan's pension. Both these pension plans also offer survivor benefits (or surviving spouse pension in Quebec) in the event of the death of a spouse or common-law partner.

However, these benefits are not one-size-fits-all. The distributed amount would be calculated on a case by case basis, depending on the age of the beneficiaries, plus for how long and how much the deceased contributed to the pension plan.

While these options are effective in making sure no one is left completely empty-handed, they are far from sufficient to guarantee your family's future. This is where insurance, and in this case, life insurance, is useful. Life insurance offers a tax-free benefit to your beneficiaries in the form of a lump sum in the event of your death. This not only means your family will have enough money to cover the loss of your income, but they’d also get much more flexibility.

Additionally, life insurance is paid with a check for the insurance amount. So if you had $400,000 of coverage, your beneficiary would get a check of... $400,000. They would be free to use as much money as they see fit to make sure the family can keep the same pace before the loss of income. Of course, it is always recommended to have the help of an expert to make these kinds of decisions.

Which type of life insurance is better suited for income replacement?

While there are two main types of life insurance (temporary ones with a fixed length and permanent ones that last your whole life), there is a clear winner in the income replacement department. You should know that at some point in the future, you won't need to replace your income anymore. This is why term life insurances, which will end at a predetermined point, are best suited for your income replacement needs.

Another thing about term life insurance is that it is more affordable than whole life insurance, since there is no guarantee that the insurer will pay the benefit. With term life, there is of course a "chance" that you will die while the insurance is active, but the odds are you won't (which is what we all wish for!). With whole life, or permanent, insurance, the insurer knows it will have to pay at some point, it just doesn't know when. This difference is what makes term life cheaper and easier to purchase.

Plus, replacing your income until your kids no longer need it (most likely when they are out of school) might require a bigger insurance amount than you thought. Being cheaper, term life insurance is the best option to take on the necessary coverage without emptying your pockets. They are also much more flexible, and you will want that since your income replacement needs should decrease as your children get older. Just like any financial plan, income replacement and life insurance should be reviewed every now and then to make sure they still align with your current needs.

How much life insurance do I need for income replacement?

While understanding the basics of income replacement is important and useful, the methods used to determine exactly how much you need aren't as fun to learn.

This is the part where the help of an expert is more than recommended since you don't want to end up paying too much for life insurance or worse, incorrectly thinking you got everything covered and leave your family with financial struggles. And with professional advice available online now, it’s easier than ever to seek an expert’s help. For example, Emma.ca, a digital-first fintech start-up like KOHO, provides custom-made insurance quotes and income replacement advice for free.

It’s become so simple to navigate the ins and outs of insurance, it’s worth exploring what you need and want to financially protect your loved ones.