How much life insurance do you need?

Life insurance may seem like a tricky product to many people, and some insurance salesmen have gotten a bad rap in the past, partly due to some life insurance products that are quite complex and difficult to understand. However, finding a reputable agent and purchasing a life insurance policy, whether it is term or permanent life insurance, may be the most important thing individuals can do to protect the financial welfare of their family in case something happens to one or both of the breadwinners.

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Where to Start?

Calculating the amount of life insurance coverage necessary may seem like a big, complicated exercise. In reality, the only requirement is looking at the financial needs of an individual or family, and projecting out into the future a little bit. The whole purpose of life insurance is to allow the family to continue its current lifestyle as planned and avoid any financial catastrophe, in the event of the family breadwinner’s demise.

Some industry experts and online life insurance calculators recommend applying a rule of thumb, such as taking out enough insurance to cover 20 years’ worth of income, held in an insurance policy that equates to a safe investment such as certificates of deposit and bonds. Some financial planners recommend the bare minimum of life insurance, while many others push way more insurance than is necessary. The whole process can be made much more simple by reviewing a few areas of an individual’s life and adding up the projected costs.

Assess the Immediate Needs

Think of the number of family members that would be left behind. It may be one person, the remaining spouse or it may also include children. Count outstanding debts such as car loans, a mortgage, student and other consumer loans and credit card balances, as these things would be a heavy financial burden to the remaining survivors. Even with paid-out insurance proceeds, the remaining family may not choose to pay off the mortgage, but at least they will not be put in a position of being forced to sell the family home. Also factor in regular monthly bills for basics like utilities and food.

Funeral Costs

This part may be difficult, but it is necessary to plan for funeral costs, include a casket, funeral plots and the burial service. Costs vary, but according to Bankrate.com, the average cost of a funeral can range anywhere from $8,000 to $20,000, although cremation costs are substantially lower. Other final costs include medical bills that might have been incurred shortly before death, probate costs and estate taxes. One of the benefits of life insurance is that the insurance beneficiaries will most likely receive tax-free life insurance proceeds faster than waiting on funds that come from the estate of the deceased.

Check Current Resources

Factor in the amount of liquid assets that are available. This will not include retirement funds inside of IRA or 401(k) accounts. The more funds set aside in savings that are readily liquid and available, the less life insurance is necessary.

Project the Future

Plan out any expenses that are likely to come up at least once during the lifetime of the remaining family. This includes wedding costs, new cars, and home maintenance and repairs. Decide how many years out into the future coverage is needed. Some families incur debts while children are younger, such as a mortgage and college savings accounts or private school bills. However, once the kids are out on their own, these costs may be paid off and life insurance may not be necessary, or a smaller amount will be needed.

Calculate the amount of costs to cover by child. If there is more than one child in the family, this will require a certain amount of funds for college, adjusted up for inflation, for each child. Overall costs for college have risen historically by approximately 5% per year. This calculation can be tricky, since it may be several years before a child is ready to go to college. However, the calculation can be done by looking at the current costs for potential colleges, and choosing whether to insure for part or all of the costs. Life insurance proceeds should grow at about the same rate as college costs, so using today’s college cost estimate will work fine.

Living Expenses

Finally, depending upon the age of the remaining spouse and children, calculate how much they would need for annual living expenses until the children have gone through college and the remaining spouse is old enough to take advantage of retirement money. This includes child-care that might be necessary if the remaining parent needs to work full-time; any school-related expenses such as tutoring or regular school fees and any other usual expenses like homeowner’s insurance and health insurance.

After major expenses such as education, debt payoff and funeral expenses are covered, the remaining family will not need a replacement 100% of the deceased’s income. Shoot for covering about 50% of current annual earnings before tax. To figure out what this amounts to as a lump sum, take half of an annual gross salary, say $50,000, and divide that by a conservative growth rate of .05, which assumes insurance benefits earn about 5 percent per year. This result says a lump sum of $1 million should be adequate income replacement.

Adjustments

The results up to this point can now be tweaked to factor in results unique to the individual’s situation. If either spouse has a history of medical issues, add $100,000 to $200,000. Getting life insurance with pre-existing medical conditions becomes more difficult and expensive as people age.

Once each of the categories have been fleshed out, add all the numbers up. This represents the total amount of life insurance coverage needed. The number may be a high six-figure or low 7-figure number. That may seem intimidating, but with the low cost of term insurance, a $1 million life insurance policy could easily cost under $1,000 per year.

Term or Permanent Insurance?

Term insurance is cheap, but once people hit age 65, the cost rises quickly. Permanent life insurance is more expensive in the initial years, but the premiums stay level for the entire life of the policy, and the investment component of the policy can pay for the premiums in the later years. Some experts recommend buying only term insurance and investing the money that would have been spent on permanent life insurance. With diligent savings, wise investing and a bit of luck with the stock market, when savings reach $500,000 to $700,000 or so, a family can consider themselves self-insured and drop the term insurance. The downside is the amount of discipline required to execute this scenario, as well as other life events that may come up which preclude a family from being able to set aside the additional savings each month.

One way to get the best of both worlds is to purchase a little bit of both term and permanent life insurance policies. Purchasing term insurance that converts into permanent life insurance is one way to save money in the earlier years by paying term rates, then convert the policy for stable premiums in later years that will most likely be lower than term insurance rates, especially for people over age 65. Some of both types of policies can be purchased and then term insurance cancelled once major debts such as a mortgage and education are paid off.

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