Buying life insurance doesn’t make sense for everyone. If you don’t have dependents but you have enough assets to cover your debts and the cost of dying (funeral, estate lawyer’s fees’, etc.), then insurance may be an unnecessary cost for you.
If you have dependents and you have enough assets to provide for them after your death (investments, trusts, etc.), then you may not need life insurance. If, however, you have dependents (especially if you are the primary provider) or significant debts which outweigh your assets, then you should consider life insurance to ensure your dependents are looked after, if something happens to you.
Which type of insurance should you get? And how much insurance do you need?
If you want to protect your family against the potential destruction of your business or the impact of estate taxes, after your death, whole life or universal life insurance should be considered. If, your main concern is to protect your family against a loss of your income, term insurance is the way to go, according to Neal Frankle, CFP, the founder of Wealth Resources Group in Agoura Hill, CA, in a column he wrote for Forbes.com
Regarding how much insurance you need, Frankle says this question is also pretty straightforward. “It takes a few steps, but it’s not rocket science.” Frankle suggests taking into consideration the following to determine how much life insurance is necessary. There are many forms of life insurance policies and contracts, so first ensure you seek the advice of a licensed and experienced insurance agent. They will help you answer the following questions and quantify how much and what type of insurance you need.
1. How much debt do you have, other than your mortgage? If you have any other debt, you are spending more than you earn. Do you add to your debt, each month? Do you pay it down, each month? If you have debt, you have to buy more life insurance to pay it off.
2. How much do you spend, each month? The most accurate way to determine your monthly need is to use a personal budget software package, like YNAB, but you can also use your bank statements to estimate your spending.
You can’t protect your family, if you don’t know how much you need every month. Don’t just guess. You might think $500,000 in term coverage is sufficient. After all, it’s a lot of money. Give it careful thought. You may find this is not enough.
If you die and your family gets the $500,000, what can they do with it? They might invest it using an income diversity strategy and maybe earn 5%. This amounts to just $25,000 of yearly investment income. So, if you earn $25,000 in salary, a $500,000 term policy is plenty. If your family depends on more than $25,000 each year, you need more coverage.
3. How much do you save, each month? If you put away money every month and live within your means, keep it up. In fact, you probably don’t need to replace all of your income, so you need less life insurance.
4. What are your longer-term saving goals? How much money do you need to retire and pay for your immediate future? Are you saving enough to fund your future automobile purchases, retirement, and education for the kids? If you have funds set up for non-recurring, but expected outlays, fine. Otherwise, you need more coverage.
5. How much income do your survivors need if you aren’t around? This is the only thing which really matters when it comes to determining how much life insurance you need. To answer this, you have to first add up your answers for the above questions.
Let’s say you know you spend $6,000 each month to pay all your bills, including taxes. You calculate this using a personal budgeting software program, so you know you are on target. Let’s also assume this $6,000 pays for everything, including future college education, automobile purchases and retirement. Of the $6,000, you earn $3,500 and your husband earns $2,500.
You run a financial plan and figure, by age 65, your maximum Social Security benefit and income from your investments will replace your earned income. This is when you retire. (Without a financial plan, it’s really tough to know how much insurance you need.)
After you do this exercise, you know you need to replace your income, until you reach 65. This is $3,500 per month for you, and $2,500 for your husband. Your monthly income is equivalent to $42,000 a year. You need enough term insurance, so if you pass away, you could invest the proceeds and earn $42,000. How do you calculate?
If you assume you could earn 5% on the money, simply divide $42,000 by 5% and you have your answer. In this example, the number is $840,000. This is how much savings you need to invest at 5% to earn $42,000.
You can’t use other money you saved to offset this $840,000. If you have savings for retirement, this doesn’t count because you still need this money after you retire. The $840,000 is what your survivors need to get through until they don’t need your income. You can offset it with other insurance you already carry or if you have savings which aren’t earmarked for retirement or other purposes.
What about inflation? As the years roll by, your cost of living goes up. This means you need more money to replace your income. On the other hand, as the years pass, you need less insurance. Why?
In this example, the life insurance is only meant to replace your income until you reach age 65. By the time you reach that age, you have enough to self-insure (meaning you pay for sudden expenses out of your own pocket). At this point, you will have passive income from pensions, Social Security and investment income. Also, your children should be independent by then, too. As you get closer to 65, your risk is lower. You have fewer years to carry the family.
This isn’t a scientific approach – it’s a ballpark calculation. But it’s pretty close to what you need and it’s a calculation you can do yourself. It’s also a heck of a lot better than a wild guess.
If inflation or interest rates change radically, you have to recalculate your needs. This is why, if it were me, I’d recommend a term life insurance policy of $1 million in this person’s situation. Periodically review your life insurance coverage with your financial advisor to determine whether you still have enough or too much.
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