Do You Need Life Insurance? If So, How Much?

by Neal Frankle, CFP ®

Do you need life insurance and, if so, how much and which kind?

 

Do You Need Insurance

 

As much as some life insurance agents like to complicate the question, it’s not hard to know if you need life insurance, which kind and how much.

Let’s assume you have dependents and you are concerned about protecting your family. Let’s also assume you don’t have much saved. (You’ll see in a minute how much you need to save in order to self-insure.) So in this case, yes, you need insurance.

And if you are interested in protecting them against an unforeseen reduction in family income due to your untimely demise, you need term insurance. (Read “Term Life Insurance vs. Whole Life.”)

You see how easy that was? We knocked down two out of the three questions just like that. All we have to do is be clear about what your situation is and what risk we’re trying to mitigate and voila, you have your answer.

(If you are trying to protect your family against the destruction of your business or estate taxes as a result of your death, you might be interested in whole life or universal life. But if you are trying to protect your family against a loss of your income, term insurance is the way to go.)

The next question is “How much?” That’s also pretty straightforward. It takes a few steps, but it’s not rocket science.

Let’s go through it:

 

1. How much debt do you have other than for your mortgage?

If you have any debt other than for your mortgage, that indicates that you are spending more than you earn. Are you adding to your debt each month? Are you paying it down each month? If you have debt, you’ll have to buy more life insurance to pay it off.

 

 

2. How much do you spend each month?

Probably the best way to know this 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 this number…so make sure you get clear on what the number is. Why? Well…you might just guess that you need $500,000 in term coverage. After all, it’s a lot of money. But if you think it through, you will see it may not be enough.

If you die and your family gets the 500 big ones, what will they do with it? They’ll invest it using income diversity and maybe earn 5% (I know they can’t do this now…but over many years it shouldn’t be a huge problem). 5% of $500,000 is $25,000, right? So, if you earn $25,000, a $500,000 term policy is plenty. If you earn (and your family depends on) more than $25,000 each year, you need more coverage.

3. How much do you save each month?

If you save money every month, that’s a great omen. It means you are living within your means. Keep it up. In fact, this might mean that you don’t need to replace all your income, which in turn could mean you need less term life insurance.

4. What are your longer-term saving goals?

How much money do you need to retire? To pay for your immediate future? Are you saving enough to fund your future automobile purchase, retirement, education for the kids, etc.?

If you have sinking funds set up to fund nonrecurring but expected outlays, fine. Otherwise, you’ll need to figure these things into your estimates. That will increase the coverage you need.

5. How much income would your survivors need if you weren’t around and for how long?

I have to come clean: the questions I asked above (1 through 4) were just to get you thinking. Hopefully, now you can answer the only question that really matters, which is stated above in #5. How much income would your survivors need if you weren’t around and for how long? That’s the only thing that really matters, but in order to answer this you have to know:

a. How much you spend, on average, to live each month.

b. How much you’ll need to spend to pay for college, replacement automobiles and other expected but nonrecurring items.

An example. Let’s say you know you spend $6,000 on average each month to pay all your bills (including taxes). You’ve calculated this using the personal budgeting software program so you know you are on target.

Let’s also assume that 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 that by age 65, your maximum Social Security benefit and income from your investments will replace your earned income. That’s when you’ll retire. (Without a financial plan it’s really tough to know how much insurance you need.)

Having gone through this exercise…you know that you need to replace your income until you reach age 65. That’s $3,500 per month for you and $2,500 for your husband – and remember to adjust that income for inflation – and we’ll get to that.

For now, let’s just calculate how much insurance you need.

$3,500 a month is equivalent to $42,000 a year. You need enough term insurance so that if you were to pass away, you could invest the proceeds and earn $42,000 after tax. How do you calculate that?

Glad you asked. You can figure this out by simply asking the question a bit differently. How much do you need to invest in order to earn $42,000 after tax each year?

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. That’s how much savings you’d need to invest at 5% in order to earn $42,000.

Can you use other money you’ve saved to offset this $840,000?

Not really. If you have savings for retirement, that doesn’t count because you’ll still need that retirement money when you retire. We’re talking about getting your survivors through until they don’t need your income. You can offset it with other insurance you already carry or if you have savings that isn’t earmarked for retirement or other purposes.

What about inflation?

It’s true that as the years roll by, your cost of living will rise. That means you’ll need more money to replace your income. On the other hand, as the years pass you need less insurance. Why?

Because, in this example, the life insurance is only meant to replace your income to age 65…remember? By the time you reach that age, you’ll have enough to “self-insure” because you’ll have passive income form pensions, Social Security and investment income. Also, if you have dependents, they’ll be independent by then too. And as you get closer to age 65, your risk is reduced. You have fewer years to carry the family.

This isn’t a scientific approach – it’s a ball park calculation. But it’s pretty close to what you’ll 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 go nuts, you’ll have to recalculate your needs. That’s why, if it were me, I’d recommend $1,000,000 in this person’s situation.

How do you calculate your life insurance needs? Is there a simpler way?

 

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