How much life insurance coverage should you have? Here are some things that a typical person should take into consideration.
Financially speaking, one of the biggest impacts that your death will have is the loss of income. If you’re married or have dependents, you should figure out how much of your income you need to replace so your family can maintain its standard of living. The first step is determining how long you would like your income to be replaced for. Do you want it to last ten years, twenty years, or for the rest of your beneficiary’s life? If you have a spouse, one thing to consider is whether he or she will continue working if you pass away or if he or she will be taking care of the children full time. If the spouse decides to continue working, the total amount needed here gets reduced significantly. Keep in mind that the money received here wouldn’t just be sitting under the mattress; it would be earning interest somewhere. To figure out the exact numbers here, you’ll likely need a financial calculator.
Something that would be good to know here is whether any debt you have will be passed on to somebody else in the event of your death. If that’s the case, you should have enough life insurance coverage to make sure that someone you love doesn’t end up paying off the money that you borrowed. Credit card debts, school loans and car payments all fall under this.
Something special to think about is the mortgage. Would you like the house to be fully paid for if you pass away? If you aren’t a homeowner and are renting instead, calculate how many years worth of rent you would like to leave behind for your beneficiary, if at all.
Children’s’ College Education
Do you want your kids’ college education paid for if something happens to you? Do you want to pay for all of their tuition or just part of it? Right now, the average cost of attending a four year university is somewhere around the range of $50,000 and is on the rise. Of course, having access to financial aid and/or going to a community college first would change this number dramatically and is something you should take into account.
Do you need to have extra insurance to cover child care? Is one of your beneficiaries disabled and has special needs? Figure out how much you need to cover these other expenses and for how long.
As I mentioned before, dying can be expensive. Final expenses include a number of different areas such as funeral expenses, medical costs, and attorney fees. If you’re leaving behind a large inheritance, you have to take into account estate and probate taxes as well (that’s something that deserves a whole post by itself). Unfortunately it’s impossible to predict how much all of those other expenses will cost. I typically recommend having a minimum of $50,000 for this area, if not more. It’s better to overestimate than underestimate for this area. [break]
Let’s say that Jack and Jill just read this post and Jack is trying to figure out how much life insurance coverage he should get. They’re both 35 years old, they both make $50,000 a year, and they have a child, Jane, who is 8 years old. [break]
If Jack passes away, he would want Jill and Jane to maintain the same standard of living that they have now for the rest of their lives. With Jack out of the picture, he figures that Jill and Jane would only need 70% of the current total household income before tax ($80,000) to continue living the way they do. Jane said she would continue working if Jack passed away, so Jack only needs to replace $20,000 of his $50,000 current income. He assumes that if the income replacement money gets invested conservatively, it could earn an average of 5% a year. So to figure out how much money Jack needs for income replacement, we take $20,000 divided by 5% which gives us $400,000. In other words, if Jill takes $400,000 and invests it so that it earns on average 5% a year, then she will be able to withdraw $20,000 a year for the rest of her life. [break]
Jack doesn’t have any debt to his name other than a mortgage. Right now Jack and Jill still have twenty years left on their mortgage and they still owe $300,000. He wants the house to be fully paid off in the event that something happens to him.[break]
Children’s College Education
Jack is willing to help Jane pay for her college education, but not all of it. He believes that Jane should work during her college career to pay for part of her education. That way, not only will she gain valuable job experience, she’ll place more value in her degree because she paid for part of it herself. He’s willing to set aside $20,000 for Jane’s education. [break]
Jack can’t think of any other expenses that might come up. He believes that the extra $20,000 a year from the income replacement should be enough to take care of things. [break]
Jack thinks that $50,000 in coverage will suffice for final expenses. [break]
Total coverage needed: $400,000 for income replacement, plus $300,000 to pay off the mortgage, plus $20,000 for Jane’s education, plus $50,000 for final expenses puts Jack’s total life insurance needs at $770,000. So if Jack passed away today, his family would need $770,000 so that they could live out the life he envisioned them living.[break]
Now that we’ve figured out Jack’s total life insurance needs, all he has to do is get $770,000 in coverage, right? Not so fast. There are a couple things to take into consideration still.
Ten years from now, Jane is going to turn eighteen and will probably be able to provide for herself, at least in part. Four or five years after that, she’s going to be done with college so Jack won’t have to worry about having that expense covered any longer. Twenty years from now the mortgage will be paid off so Jane won’t need the $300,000 in coverage to pay off the house. The point that I’m trying to get at is that life insurance needs change over time and so Jack is going to have to reevaluate his polices to determine if he’s underinsured and leaving his family unprotected or over insured and paying for something he doesn’t need.
Additionally, he needs to think about what combination of policies he’s going to use to cover his insurance needs. How much of the coverage is going to be term insurance and how much is going to be permanent? Is he going to use whole life, universal life, variable life insurance or some mixture of three?
There are many different kinds of policies out there and you want to use the ones that fit your needs the best. Every person’s situation is different so there’s no catch all policy that can be recommended to everyone.
Previous life insurance post: Why Life Insurance is an Important Part of Your Financial Plan