Do you need life insurance and, if so, how much and which kind?
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.
Neal’s Notes: Sometimes, agents will tell you to exchange your life insurance into a new policy. This might be smart in a few cases, but it’s often a ploy to generate commissions. Beware if your agent suggests this move.
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?
Term is definitely the way to go. I like the idea of investing the difference like Suze Orman talks about. Also I know first hand why we need life insurance. I watched my Dad pass away at 53, and leave my mom with a mortgage and barely any retirement savings. Now she lives off social security and whatever I can help her with. You can get such cheap term today, mine costs about $25 a month and it is a substantial policy. Just watch out for the life insurance salesemen. They always try to sell whole life because they don’t get much money from commissions with term. The system really needs to be redone, but we do need insurance.
Neal,
How do I contact you off-line for a quick question on a policy I have sitting in a FedEx package ready to sign? I have been going through the Dave Ramsey series and he is totally against whole life policies as the companies make millions of of you. Can you shoot me an e-mail?
Neal, we didn’t get into the details of his idea so I don’t know what he’d recommend but I’d guess 30 yrs would probably be fine. They (the kids) could always add to or layer it with other policies as their families grew, plus many companies offer work term options. I think having two; a work and private option is a smart move. That way if you change jobs or are waiting to be eligible for new company benefits you aren’t exposed completely.
I would agree, most families don’t have enough term coverage.
To all those husbands wondering what they can do to build security and trust for their wives (typically a huge female need in marriage). Buy AND maintain proper insurance. If If you are hestitant to spend the money, I’ll just say you have no idea how huge of a return this is for the quality of your relationship, the measage it sends about how much you care. Give her piece if mind that she’ll be taken care should something happen. I know you are practically invincible Superman and nothing bad happens to fabulous guys like yourself but don’t do it for those reasons. Do it for the contribution it makes to her ” I feel loved and taken care if bucket.” HUGE dividends I’m telling you. Lots of women out live their husbands. You want her singing praises to your name if you do go one before her. Hopefully she’ll miss you too because you loved her right. If you’ve made mistakes here’s your chance to start making them right. Sorry, my soap box …
We are enjoying the articles on your website Neal and currently reviewing YNAB.
Our financial advisor dropped an idea the other day… I really liked it. Assuming ones own finances were healthily … He suggested buying term insurance for your college age kids, holding the policies and paperwork for them, maintain the premiums as a gift to them, add the spouse as they marry and then as they get settled post college / kids, into a house etc hand off the policy and premiums. Wonderful gift, locks in low rates for them and helps protect your own nest egg a bit should something happen in their young years causing them to turn to you for support.
It’s a great idea. I love it. I’d go for the 30 year – or longer if available. But how much did he suggest you buy?
As the claim you are spending more than you earn by saying you have any debt other than a mortgage, I find not completely true. The other debt I would also exclude from that category would be student loans. Yes, while you are a full-time student (Especially if you have to put yourself through like what I have had to do instead of having your parents put you through), it is rather obvious you are spending more than you are earning as the biggest chunk of that money IS going to the school. You could technically apply that very same argument to buying a home with taking on a mortgage. As such, I also would exclude the student mortgage from the claim you are spending more than you are earning.
I am having to spend another $20,000 or so total in addition to the total of $55,000 between myself and my wife’s prior education, just so as I can finally have that 4 year degree even though that also meant I had to earn a total of 341 quarter credit hours due to the first school going belly up only for the state board to have no record of it for me, and that has done all but null and voided out my Associates of Business Administration in Accounting that only took me 4 quarters to earn 93 quarters hours and work 20 hours a week as CO-OP in the 4th and final quarter I needed to get that degree. The first 3 quarters, I earned 77 hours with the 4th quarter being only 16 hours, yet, it seemed as those classes were easy to me because I already had it in high school. I also picked up 102 semester hours at Xavier University in the same Accounting degree, but still fell by 27 semester hours to get the degree which their unethical actions against me had a significant impact on me. Now I am having to finish out my Accounting degree at University of Cincinnati, though it still meant about 2/3 of those courses has been review/repeat for me just as about 45 of those semester hours at Xavier University were review/repeat for me. At least University of Cincinnati seem to not commit unethical actions as Xavier University did with me, and University of Cincinnati didn’t attempt to tell me I had to attend college during the summer just as Cincinnati Metropolitan College attempted to force me, which I ended up having to fill out the FMLA forms with my doctor filling out his part and signing off on it just so as I could get that summer off and go through with the second phase of testing and as the testing showed, I went through with the operation to get rid of them blasted epileptic seizures permanently as they were otherwise only getting worse as time progressed. But then I also never saw the $11,000 refund from CMC that was due to me, even with me filling out the paper work dealing with CMC’s bankruptcy case.
My case is such an extreme case dealing with having to put myself through college, if I hadn’t taken on as much of a course load as I have in the school year of 2011-12 (18 hoours in the Fall, 20 hours in the Winter, and 19 hours in the Spring) to set up the stage for me to graduate in December 2012, I would have had to finish out my higher education without the Pell Grant as after the Fall Semester of 2012 is done (Yes, University of Cincinnati is switching from quarters to semesters, thus why the difference), I will have used up all 6 years worth allowed by the Federal Pell Grant. The sad thing about this whole story, the higher education industry is setup primarily to make money off of people as much as they can. I will have only a 4 year degree in Accounting even though I will have earned enough credit hours to have been in school for 7 years and 2 quarters worth without even having changed major once.
I would have finished up at Xavier University, but that unethical situation left a very sour taste in my mouth, and given the 10 year time clock had expired, Xavier University would have required me to take all 129 semester credit hours all over again. I don’t think so. It’s bad enough University of Cincinnati required me to take about 67 of the 95 credit hours which I already had from before, but yet, I will have earned all 95 of those credit hours in just 15 months, much like what I did at CMC earning 93 credit hours in just 15 months, but only in that case, I didn’t take any classes in the summer within that 15 month time period. This year, I am currently taking 11 credit hours this summer. I could have chosen to not take courses this summer and then take the 21 semester hours that converts to 32.5 quarter hours this fall, and still have those credit hours within 15 months, so in that regards, it’s very similar to the CMC case, except this case, I want to be able to focus more on my career this fall.
Anyhow, for the additional $20,000 for those 95 hours, I should be able to pay that back within 5 years time. I know my case is an extreme case of what higher education is like, but let’s just say I learned so much from all of these different situations to the point I have not only decided to NOT have any of my kids go to any school but to a university. Schools like Brown Mackie, I won’t even remotely thinking about sending my kids to as they pose the same risk as Cincinnati Metropolitan College did. I am very doubtful of even sending my kids to Cincinnati State, even though they have transfer agreements, but how do I know every single credit hours from Cincinnati state will apply to every single credit hour within the major without requiring the student to take any other credit hours (I.e. if the major requires 129 semester credit hours, then will some credit hour(s) from Cincinnati State not count towards that 129?). As such, I am even there doubtful of sending my kids to Cincinnati State. The other thing I will definitely be asking will be involving questions dealing with the integrity of the schools including their financial aspects.
Tom,
Given the situation, I don’t see why they’d need insurance. As I try to point out, the insurance is to replace earned income. Seems like this couple is doing nicely on passive income. Hence, spend the money on a nice trip to Florida rather than on insurance they likely don’t need.
More a question, rather than a comment: A couple, man 70, woman 69. Both retired. Wife has a good defined pension. Man has Rsps, which will be turned into a RIF in 2011, and then drawn upon in 2012. At the moment, their combined income, including woman’s pension, social security and investment income, is about 85,000 per year. House is paid for, as are other amenities, such as cars. No debts. Only dependent is a relative to whom we send 250 each month, to help him out. Net worth is over 1 million.
The question I have is this: do these people really need life insurance?
This is a very good, and much needed article. Most people don’t have nearly enough life insurance for their family’s needs. You make it very clear.
Some folks might think it’s overly complicated, but I don’t. Really, is it suggesting too much to spend an hour of your life to make sure you take care of your family properly? Everyone has an hour.
I think your approach is a good one. I like the emphasis on funding future needs. I don’t think it is ever safe to assume that this has been factored into the monthly budget.
I am glad you mention the need for a financial plan. Once you have that in place this exercise is a fairly simple one. Without it you are pretty much stuck using rules of thumb to determine insurance needs.
There are only a couple of things I would add to your analysis:
1. It is important to factor in social security survivor benefits, especially for young families. In my case, with three kids from 2-6, my wife will receive a sizeable benefit for the next 12-16 years.
2. A line by line evaluation of the budget is a good idea to see what expenses would change if one spouse were to die. I often find that this washes out as several things would likely go down (food, clothes, transportation, etc.) while others may go up (health insurance, child care, etc.). However, some large expense may go away altogether. For example, I have a client that is the primary wage earner and has a fairly expenses hobby (flying) that would go away if he were to die.
Thanks for the post. It is good to get people thinking about this issue.
Kevin,
Right you are.. I’m going to be writing on that subject soon. (SSI)
Thanks Man.
I like your approach, as it is very thorough. But it is also complex. The simpler way would be to approach it from the other side of the coin – replacing lost earnings instead of funding future costs. Here’s an example:
Current Net Income After Taxes: $100,000
Age: 50
Expected Retirement: 65
Since you are expecting to work 15 more years and earn $100,000 per year, you would buy a term life insurance policy for $1.5 million.
That’s not nearly as thorough as your approach, but if you are looking for a simpler approach, that’s how I’d do it.
Doug,
I like your idea man. The simpler the better — but why didn’t you tell me this before…I could have saved writing this entire piece!!!!!
Just kidding…..
As long as the $100k income INCLUDES funding for all future needs – no problem. This approach w/work. I still like going thru this exercise because it’s important to really understand all future costs.
Thanks Doug
Neal