How Much Umbrella Insurance Coverage Do You Need?

It does not matter how large your portfolio is or how dialed in your retirement plan seems to be. If you don't have the right protection in place, it can all be undone in a hurry. That's why today, we're going to be talking about umbrella insurance, so that you can understand how it best fits within your overall financial plan. This is another episode of Ready for Retirement. I'm your host, James Canole, and I'm here to teach you how to get the most out of life with your money. And now, onto the episode. Too often, I see people create financial plans that are only focusing on the quote-unquote fun stuff. They talk about how their investment portfolio needs to be allocated. They talk about income strategies and how to maximize that. They talk about minimizing taxes. Those are all great things. Those are all things we should focus on and we here at Root do spend a lot of time focusing on. I almost think of these as offense. They're designed to create something. They're designed to take what you have and make it better, but you also have to focus on defense. Now, sometimes defense isn't as fun to think about, but defense is things like insurance protection. It's things like estate planning. It's the things about how can you do the right steps or how can you take the right steps to protect the income, the investments, the tax strategy that you have in place. So that's why in today's episode, we're going to be talking about one important aspect of insurance, which is umbrella insurance. This episode is based on a question from a listener and this listener or this question comes from Tom. Tom says this, he says, I have a question about umbrella insurance and specifically, how does someone determine the amount of umbrella insurance to buy? Do you buy an amount equal to your net worth and then keep pace with inflation as it changes? Or is that excessive slash unnecessary? Basically, is there a best practice to use? Well, Tom, thank you for that question. The answer is yes, there are some best practices to use and that's exactly what we're going to focus on today. But real quick, want to highlight a recent review, the review of the week, just as a value from this podcast, then I'd really appreciate you taking a few seconds and leaving a review. This one comes from username and the username is just grateful for the show and the title is fantastic podcast, five stars. Then goes on to say, James does a great job of explaining tax planning concepts in a way that is easily understood and digested by the listener. He demonstrates a command of both old and new tax law and is able to pass his understanding along to the listener without using jargon or difficult to understand tax language. He carefully explains in words that the layman can understand, making sometimes difficult concepts very easily understood. As a family on the cusp of fire, so financial independence retire early, I am truly grateful the show exists. Well, thank you for that review. I'm really glad that you found the show and that the show has been helpful. And for all of you listening, really glad that you spend some time with me each week, listening to some of these episodes and appreciate you all doing so. So with that said, let's jump into umbrella insurance. I think this is one of those things where sometimes there's the concept of, oh, you have to be very wealthy to have umbrella insurance. And sometimes there's the thoughts of how much umbrella insurance do I even need to have. Today, what I want to do is help to define what is it, help to understand how much of it do you need and help to understand what aspects of your financial plan or of your net worth maybe aren't necessary when calculating how much insurance is needed. So let's start by understanding what does umbrella insurance cover and then some details that are important to know. So you can see how it might fit into your overall insurance coverage and your overall plan. But to start, what does it cover? Well, it covers injuries. It covers damage to property. It covers certain lawsuits. It covers personal liability situations. So it's kind of in some ways like a catch-all because the different things that can happen to you. Now, if you do something on purpose, if you injure someone on purpose, that's not covered by this. But if you have liability, someone falls and breaks a leg in your property, or you unintentionally crash into something or someone with your vehicle and you're at liability or you have liability because of that, this is where umbrella insurance might come in. Now, a few details. Umbrella insurance supplements your auto insurance and your homeowner's insurance. So that's kind of like your first layer of defense. If you have a car, you have a state mandated minimum insurance amount, but hopefully you have more coverage than just that. In that coverage, one aspect of it is liability coverage. Same thing if you have a homeowner's insurance policy. You have different things that it covers, and one of the things is liability. So how do you protect what you could be liable for? So if there's an event and something happens to you, your home insurance and your auto insurance, those are your first lines of defense, but there are caps on how much liability coverage those policies will cover. And typically on the high side, it's $500,000 of liability coverage. So if you have something that happens and you have liability in excess of that $500,000, that's where umbrella insurance comes in. And I shouldn't say in excess of that $500,000, I should really say in excess of whatever the caps on your specific policy. So once auto insurance or once homeowner's insurance pays out, then umbrella insurance kicks in. And with umbrella insurance, you can buy it in increments of a million dollars. So it's larger increments. Now, the good news is it's typically on the cheaper side. When you look at how much you're paying for that million dollars of coverage, it's less than you would expect to pay for other types of coverage to the same amount. And when you look at this as well, your umbrella insurance is going to have requirements in place for what your auto and home liability coverage protects first. Because it's sitting on top of those policies, essentially, your umbrella coverage, your umbrella insurance provider is going to say you need to make sure you have these coverages in place first. This is why a lot of times people will bundle their auto insurance, home insurance, and umbrella insurance because the policies sometimes fit nicely together. Not always, but oftentimes. But your umbrella coverage is going to have requirements for what needs to be covered first so that your umbrella insurance coverage can come in above and beyond that. One nice thing about umbrella insurance is it not just covers the policyholder, but it also covers other members of the family or the family's household. So for example, if I purchase an umbrella insurance policy and my daughter, now my daughter's one, so hopefully she's not getting into too much trouble today, but let's fast forward 10 years, 15 years, 20 years, something happens with my daughter and her friends on our property, well, my umbrella coverage or my umbrella policy would also cover any of those types of things. So it covers the household. Now, as I mentioned, it does not protect the policyholder's property or liability due to damage caused on purpose, but anything that was an accident or any accidental liability, that's what it's covering. So that's a very high level overview of what it is. Let's start talking about the practicality of this, of how much coverage do you actually need? And I guess before that, do you even need coverage? So to determine that, there's really four things that you need to know, and I want to kind of outline what each of those things are so you can start to work through this and say, do I need umbrella insurance coverage? And if so, how much? So the first of the four things that you need to know when you're trying to determine how much umbrella insurance, if any, do you need? Well, first you need to know your net worth. The reason you need to know your net worth is if your net worth is only say 200,000, well, you don't need $10 million of umbrella insurance coverage. No one can really come after you for more than that 200,000 in most cases. So to get an umbrella insurance policy above and beyond that, unnecessary expense. Now, big, big, big disclosure. Before you go out and implement this and buy coverage, talk to your insurance professional, talk to your financial advisor. There are some nuances and some details that you really want to make sure you have covered and have an understanding of before you purchase your policy. But I do want to give you a high level overview of this. But the first thing is your net worth. You shouldn't really have umbrella insurance that's significantly higher than your net worth because what you're doing is you're kind of covering nothing. You're insuring nothing because it's not like you have that net worth that even needs to be covered yet. Now, thinking forward to the future, your net worth probably will be rising as you're working and earning and your portfolio is growing. So it's not like you can get umbrella insurance once and be done for the rest of your life. But do know that the amount you need today is based on your net worth as a starting point. So that's number one, real simple. Now, just because you have a net worth of, say, 2 million or 3 million or 4 million, that does not mean you need umbrella insurance coverage of 2 million, 3 million or 4 million. So let's go to the second thing that you need to know when determining how much umbrella insurance coverage do you need. The second thing is how much home equity do you have up to your state's exemption limits? So every state, with the exception of Pennsylvania and New Jersey, every state provides what's called a homestead exemption amount. And that's going to protect you, at least part of the equity in your home, from creditors in the case of bankruptcy. Now, this is really why we have umbrella insurance, right? Is to say, how do we protect the assets we have if there's creditors coming against us or a judgment made against us? Now, Pennsylvania and New Jersey, quick side note, those residents still have a little bit of an exemption they can look at, but they're just using the federal exemption amount, which is pretty low. It's around $28,000 or so. So most states, every other state besides those two, they have separate exemption amounts. And let's explain how that works by looking at an example. I'm in California. California has an exemption of $600,000. Now, quick note, this is equity in your home, not your home value. But what this exemption says is creditors cannot come after you for any equity in your home that's under that exemption. So let's say you own a home for a million dollars. You say, oh, well, is my home exposed? I have a million dollar home and the exemption amount's only $600,000. That means technically a creditor or judgment could come after me for $400,000. Well, again, it's not necessarily the home value, it's the equity in your home. So if you have a $600,000 mortgage, then really your equity is $400,000. And because that equity is under the exemption amount, you're good in that scenario. So this is why it's important to understand both what is the equity that you have, and then number two, what are your state's exemption limits? Because when we go back to step number one, which is, hey, determining your net worth, your whole net worth doesn't necessarily need to be covered. What if your entire net worth was $600,000 and it was all in your home and you live in California? Well, in that case, you're kind of good. You have an exemption amount that's going to protect you against a judgment to protect you against creditors. And again, that is the goal of umbrella insurance to protect you against creditors in some type of a judgment. Now you have to keep in mind that your home value likely will rise over time. So it's not a set it and forget it, but do understand of your overall net worth, how much of that is already protected based upon your specific state's exemption amounts. Now there are rules around how long you have to have lived in the states. There are other details. So as I mentioned in my disclaimer before, check with your financial advisor, check with your insurance professionals, make sure that you have the right plan in place. That is an important aspect to know. So number one, know your net worth. Number two, know how much home equity you have and what your state's exemption limits are. And then number three, understand the value of your retirement plans. I don't mean understand your value in the sense of what this can do for you, but literally understand what is the value of your retirement plans. By retirement plans, when we're looking at this, not just funds that you have earmarked for retirement, but specifically assets inside of a qualified retirement plan. So retirement plans that are under ERISA coverage, they have creditor protections built in. So ERISA, things like your 401k, things like most 403b's, things like health savings accounts, rollover IRAs, those have ERISA protections. There are a lot of protections built in to the extent that those aren't subject to creditors. Those aren't subject to any types of judgment against you. So if you theoretically have $10 million, but it's all inside of a 401k and you have no other assets, you really don't need umbrella insurance. There's already protection in place for those assets. Now, Roth IRAs and traditional IRAs that you contributed to, they are currently protected as of 2023 to a total dollar value of $1,512,350. So a very specific amount, but it's around it to $1.5 million per person. Now you might be thinking, James, you just said traditional IRAs are subject to, or have protection up to 1.5 million, but rollover IRAs are totally protected. What's the difference? Well, a rollover IRA originated inside of an ERISA protected plan. A rollover IRA is something that used to be in a 401k, for example, and then you rolled it over to an IRA. So they're going to look at that as saying, okay, that originated in an ERISA protected plan. Therefore, those protections are still granted to it versus a traditional IRA that you just contributed to that never had ERISA protections to start with. It was just money you were contributing of your own accord, and it still has significant protections. 1.5 million is pretty significant per person, but there is that slight difference. So generally speaking, your retirement plans aren't going to be subject to creditors for most people. And I say for most people, because some people will have retirement plans in excess of $1.5 million that were contributed or funded solely by Roth IRA or traditional IRA contributions, but it's not very common. There are a lot of people who have IRAs and Roth IRAs combined that are in excess of that, but they oftentimes accumulated those assets through at first contributing to some type of 401k. So make sure that you have an understanding of how much or what's the value of your current retirement assets. Where did those contributions originate to see are these assets that could potentially be subject to creditors or are they already protected in their current form? So that's the third thing that you need to understand. And then the fourth detail that you need to know is what's the limit of your auto liability coverage or your homeowner's insurance liability coverage. So again, there are state mandated limits for auto insurance of how much do you have to have in liability protection. It's typically pretty small, might be $10,000 or $15,000 per driver. Well, if you can get higher coverage, typically I recommend that, but let's assume that you have a $500,000 liability coverage on your auto insurance policy and you have $500,000 liability coverage on your homeowner's insurance. Well, your umbrella insurance kicks in after that. So you have to ask yourself, what exposure, if any, do you have above and beyond your auto liability coverage or your homeowner's insurance liability coverage? Because if your overall net worth is say under $500,000, but you have both $500,000 liability coverage through your car and your homeowner's insurance policies, well, you probably don't need umbrella insurance. Again, umbrella insurance is designed to protect any of your net worth and access of that that's not protected by something like being inside of a retirement plan or being under your state's exemption limit. So once you know these four details, your net worth, your home equity, up to your state's exemption limits, the value of your retirement plans, and then the limits of your auto liability coverage and your homeowner's liability coverage, at that point, you can start to solve for how much, if any, umbrella insurance do I need? So the basic formula for this, and again, use a basic formula as a starting point, but please check with your insurance professionals and financial advisor, because insurance is one of those things that you don't want to get wrong. But the basic formula is you start with your net worth, back out any of your home equity up to your state's exemption limits, back out the value of any retirement plans you have, or maybe only up to a certain amount, if it's an IRA or a Roth IRA, and then back out the limits of your auto liability coverage or your homeowner's insurance liability coverage, the lesser of the two, and whatever is left, that's what needs to be covered by an umbrella insurance policy. So what you'll start to see here is your need for umbrella insurance, it doesn't come down to your net worth. It comes down to your net worth, but in context of this very basic formula. For example, let's look at two different couples, both of which live in California and both of which have a net worth of $4 million. At first glance, you might say, well, if they both have the same net worth, doesn't that mean they need the same umbrella insurance coverage? Well, not necessarily. Let's say the first couple, again, they're in California, they have $600,000 equity in their home. Well, we already established that California has the exemption of up to $600,000 of equity in your primary residence. That's not subject to creditors or judgment, assuming you didn't do anything intentional to harm anyone. Then let's assume that each of these individuals has exactly $1.5 million in their 401k. Well, 401k, they provide full protection against creditors. So no coverage really needed for that. And then they have homeowner's insurance and they have auto insurance, both of which provide $500,000 of personal liability coverage. Well, when we see all that and we say, okay, they have a $4 million net worth, but of that 3.6 is excluded because of state exemption amount and because of the money being in plans that are covered by ERISA, that only leaves $400,000 that's really subject to creditors. And if they have $500,000 of personal liability coverage already via their auto and homeowner's insurance policies, this couple may not need an insurance or rather an umbrella insurance policy on top of that. Now, ideally, this couple is doing some forward-looking planning and they're projecting out and they may say, you know what? Our net worth today doesn't require an umbrella insurance policy, but we may grow into it. We may need one in the future as our net worth continues to grow. But anyways, that first couple maybe doesn't need one. Compare that to another couple, also living in California. In this couple, they have $4 million of net worth, but it's all in a non-qualified investment account. They sold a property, they sold a business, whatever the case may be, they have $4 million and it's not inside of a 401k or ERISA covered plan. It's not in a primary residence. It would have some of that amount exempt. What they have, assuming they have the same $500,000 of personal liability coverage on their auto insurance and homeowner's insurance, well, three and a half million of their net worth is still exposed. So this couple would likely need to look at an umbrella insurance policy. And because umbrella insurance policies are sold in increments of a million dollars, they would likely need a $4 million policy to cover the three and a half million dollars of exposed net worth that they have. So that's the way that I would recommend looking at umbrella insurance and your need for it or your lack of need for it. The other thing to keep in mind, though, as you're looking at this is this is not a one and done thing. So especially if you're getting umbrella insurance coverage earlier on in, say, your working career, and as you keep working or your portfolio keeps growing, your net worth keeps increasing. You can easily grow out of an umbrella insurance policy. So you need to make sure that you're keeping up with that to make sure that you don't get something that works for today. But then a couple of years go by, you sell a business, you sell a property, your portfolio grows, whatever it might be, and you're no longer fully covered anymore. So make sure you're staying on top of this. But by understanding this basic framework of what is exposed to creditors, what is exposed to a potential judgment, and what's not, that's the framework that's going to allow you to see what coverage you need for yourself. So with that said, Tom, thank you very much for this question. I hope that was helpful. Thank you to all of you who are listening, and I'll see you next time. Scroll down just a bit on that page and then click submit a question to submit a question that we'll answer in a future episode. Again, that can all be found at RootFinancialPartners.com. Thanks as always for listening, and I'll see you next time. Bye.