You've decided it's time to get life insurance. You know why you need it. There's just one other hurdle; you're asking yourself, "how much life insurance do I need?"
This can be more difficult than figuring out how much health insurance or car insurance coverage you need. You're required to have these, and each has a minimum amount of coverage needed.
With life insurance, you're not required to have it, and there's no minimum required amount you should have. So, if you're confused about your life insurance needs, this guide will help you decide home much coverage you need and different ways to calculate your need without overpaying.
We want to help you save money while also ensuring your loved ones won't be left in a difficult financial situation.
"Death is one of the few things that can be done as easily lying down." – Woody Allen
Let's assume you know the difference between term and whole life insurance. Don't worry; we're not going to get into anything related to a cash value or variable life insurance products.
Hopefully, by the time you're done reading this, you will have a clear idea of how much life insurance you need. Then you can get over this hurdle and find the most suitable policy for your needs.
Why Life Insurance?
First, why is it called life insurance? We probably can't call it death insurance because people don't like talking about death.
Plus, can you imagine if you were a life insurance agent trying to sell death insurance? Most people would avoid you even more. Calling it life insurance doesn't feel so dark and scary.
So, let's talk about your death!
Life insurance is important. You need it if you love someone or owe someone.
Families that need life insurance own insufficient amounts. According to The Life Insurance and Market Research Association_,_ "less than half of the middle market consumers ages 25 to 64 own individual life insurance policies."
More staggering is those who own life insurance policies have an average of $167,000 of coverage. After subtracting burial expenses and medical bills, that would only replace about two to three years of disposable income for most families. Yikes!
So, How Much Life Insurance Do I Really Need?
Once you've decided that it's the right time to get life insurance, the next step is figuring out how much you will need.
Life insurance agents and financial planners have occasionally told their clients to own a multiple of their salary — for example, 5 or 10 times their earnings on an annual basis. You've probably even seen this recommendation online.
However, this approach doesn't take into consideration that life insurance needs vary widely among different families. That's like going to the doctor's office, and they prescribe everyone the same pill. It doesn't work.
Your family size, career, assets, and liabilities, and your goals should all be considered when deciding how much life insurance to get.
Here are two different ways to calculate how much life insurance you need:
- The human life value approach
- The needs approach
The Human Life Value Approach
You can't really place a value on human life, but for insurance purposes, you can. We first look at what is the present value of all your future earnings. The goal here is to provide income to your family in the event you pass away unexpectedly. Here's how to do it:
- Take your average annual income
- Deduct taxes, health, and life insurance premiums and personal care to get to the number needed to support your family every year
- Figure out how many years until you retire
- And then let’s use a pretty reasonable discount rate to arrive at a number
For example, let's say Scott (27) makes $50,000 a year and for simplicity's sake plans to earn that much on average annually until he retires at age 65. He's married and has one child. $10,000 is deducted for taxes, premiums, and personal care, which leaves $40,000 left to provide for his family. All of the future streams of Scott's income will be discounted back at 5% to the present value.
Running a quick calculation, we get a present value of $674,715. This dollar amount is what Scott's family would lose out on if he were to pass away. The great thing about this approach is it measures the human life value of an individual, not just a multiple of what they make.
You need $674,715 with the human life value approach.
This method is a better way to measure how much life insurance you need but has a lot of limitations. It doesn't take into consideration other sources of income like Social Security survivor benefits, income from retirement accounts, or pensions.
Second, it doesn't take into consideration Scott's occupation, employee benefits, or future earnings potential.
Third, it's assumed that expenses will remain the same and doesn't consider inflation.
Finally, probably the most important thing is the rate of return over 38 years. That could have a significant impact as well as any unexpected life events like a divorce, new child, or death in the family.
It is hard to get to the exact amount of life insurance you need. If you want a more accurate number, lifehappens.org has put together a human life value calculator that accounts for things like age, gender, occupation, increases in earned income, consumption needs, employee benefits, and wages earned by a working spouse. When you think of all these things, the human life value becomes much higher!
The Needs Approach
The second way to decide how much life insurance you need is to use the needs approach. This takes into consideration all of the different family needs you may have and how it can change over time.
First, you will need to add up all of the current life insurance (if there is any at all) as well as all of your assets and then subtract this number from the total amount of life insurance needed.
Some of the most common financial needs are:
- Immediate needs: Cash to pay for burial expenses, funeral expenses, medical bills, estate expenses, and more.
- Income needs : Initially, the beneficiaries will need income to support their current lifestyle along with income to support future income.
- Retirement needs: This is when many people start looking at cash-value life insurance, which we won’t get into.
- Other needs to consider: When the mortgage will be paid off, if the children or spouse plan to attend college, major dental repairs, home repairs, and car repairs. All of this requires an added level of care in a family with a mentally, physically, or emotionally challenged family member.
Once you've determined the needs, the next part is running some calculations to get a number.
First, let's look at an example; David and Kelly are married and have two children, ages 6 and 4. David (35) earns $60,000 a year as a marketer, and Kelly (33) earns $35,000 as a teacher. David wants his family to be taken care of financially if he were to pass away.
He thinks he'll need $15,000 for funeral expenses, $5,000 for deductible and coinsurance on medical bills, $12,000 to pay off the car loan and credit card, and $3,000 for attorney fees.
David also wants to ensure his family has monthly income until his youngest child turns 18. Kelly thinks they could live on 75% of David's take-home pay pretty easily. That's $45,000 or $3,750 per month. Kelly may work part-time as the kids get older but does not want to rely on that expectation.
Kelly and the kids will qualify for social security survivor benefits. Let's assume they receive $2,000 per month from this. That leaves a need of $1,750 per month. $294,000 in life insurance will cover that until the youngest child turns 18.
When you add it all up, David would need a minimum $329,000 in life insurance coverage to cover the necessities of his wife and kids.
Kelly also wants the mortgage of $152,000 to be paid off, an emergency fund of $10,000, and an education fund of $80,000. More would be recommended to live a better quality of life and pay for things like sports, vacations, repairs, etc.
You will need $571,000 under the needs approach.
The Bottom Line
By now you should have a good idea of how to arrive at the amount of life insurance you need.
It's time to get that policy in place. Don't let the topic of death keep you from getting life insurance. The most important thing has something in place.
Even if it's a $250,000 or $500,000 life insurance policy, it's better than nothing.
If you are worried about how much a life insurance policy may cost, you can request a free quote from Bestow. With Bestow you can purchase a policy for as little as five dollars a month and skip the hassle of dealing with agents and doctors. Getting the right amount of life insurance for your needs has never been easier.
Written by Michael Dinich for Your Money Geek and legally licensed through the Matcha publisher network. Please direct all licensing questions to firstname.lastname@example.org.