Once you know you need life insurance, the next thing to figure out is, How Much?
So, you have done some research and now understand that you need life insurance. The next question to answer is how much life insurance you need. This is obviously a personal question to answer and it depends on what you want that insurance to accomplish. Do you want to replace your income, pay for specific expenses like college for kids or the mortgage?
How much life insurance you need also depends several other factors. The first of these factors to consider is your phase of life. Generally it can be said that there are five phases of life: youth, young adulthood, adulthood, mature adulthood and old age. Each of these times of life have different insurance needs attached to them and the amount recommended usually goes up over time.
The amount needed goes up over time because of the next factor in determining how much life insurance is needed which are the events that happen throughout a person’s life. Events like a marriage, buying a home, raising a family, a divorce, major illness, parents healthcare, children’s college, and many more dictate how much life insurance is appropriate.
There is usually a progression of these life events which add responsibilities or obligations and that is why there is an increase in the amount of life insurance that is appropriate. Also, since these progressions are usually expected in the future, and life insurance is very inexpensive when the insured person is young it can make some sense to consider future life insurance needs when determining the amount to apply for.
There are a couple “Rules of Thumb” that many people in the insurance industry use to estimate an individual’s life insurance need. One is seven to ten times the insured person’s salary. Another “Rule” is that annual salary divided by a percentage (often 4%). This implies that the salary of the insured person could be replaced by a 4% interest, or return on the death benefit. For example, a $50,000 salary divided by .04 would equal a $1,250,000 Death benefit.
These kinds of tools are helpful to a point but are not personalized for your needs, so wouldn’t a more precise measurement make sense? A Financial Needs Analysis is the more detailed and personalized measure for how much life insurance is needed. This financial needs analysis looks at the lump-sum needs at death and also any ongoing income needs.
Immediate Needs From Life Insurance
The lump-sum needs are many immediate costs including final illness costs not covered by other insurance, repayment of outstanding debts. Other immediate costs would include:
- Funeral, Burial or Cremation
- Probate Costs, or Attorney’s Fees
- Any Estate Taxes
- Short-term cost of running the survivor’s household
The death benefit should also include an emergency fund to handle any unexpected additional expenses. Survivors typically have enough to worry about needing to worry about the expenses of a house, car or appliance repair. How much should be calculated for the emergency fund depends on the remaining assets and their liquidity.
Many planners suggest prefunding anticipated college expenses for children out of the lump assets rather than funding through income. The amount needed can vary wildly depending on the college to be attending. The State University, or the local community college will have a lower tuition than an Ivy League school, and living expenses while living away also add up. Planning for a child’s advanced degrees also take more time and money.
Education expenses can also include training for vocational changes for the surviving spouse.
Income Needs From Life Insurance
After all of the more immediate needs are accounted for, ongoing needs (income) is the next thing to consider when determining how much life insurance you need. And, how long that income s to last.
Income should at first cover an adjustment period to get used to the new situation. After that time there needs to be enough income to maintain a standard of living. Since some of the expenses like debt, or potentially, the mortgage were paid off with the lump sum the monthly expenses should be lower.
You can make a list of all current budget items to determine the household’s required monthly income or use a factor of 60-70% of current income provided from the insured person to continue.