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How Much Life Insurance Do You Really Need?

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Steve Pomeranz, How much insurance do you really need
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Life Insurance for the Attention Span Challenged

Today I want to help you understand a topic that many may find a little bit morbid, dull, and baffling: Life Insurance. Okay, before you zone out, you should know that, short of dying rich, life insurance is probably the best way to take care of your loved ones after you’re gone.

Most of us are naturally reluctant contemplating our own death or the demise of our loved ones, but for the sake of your family and your peace of mind, you need to overcome this aversion and face up to it.

Okay, so I’m not going to try to convince you that the subject is fun, but I would argue that it’s not as hopelessly confusing as you might think it is.  I’m going to try to walk you through it in simple and practical terms.

If this in any way sounds like a sales pitch, it’s not and I don’t think everyone needs life insurance.

But the question is: Do You Need Life Insurance?

Well, who needs life insurance and who doesn’t? This answer is easy: if you have dependents—children, a spouse—or if you don’t have adequate savings or other assets, life insurance can replace your lost income if you die.  If you want to provide them with a similar lifestyle to the one they’re accustomed to, life insurance can fill this role in your financial plan. By lifestyle, I mean annual income to cover recurring costs like rent, food, and bills but might also include major one-off expenses like college tuition or a new car, for example.

Basic Options in Life Insurance

On to the thornier part of the life insurance puzzle: what kind of life insurance makes the most sense in your case?  There are two basic categories: term life and permanent life policies. Permanent Life goes by many names: Cash-Value, Whole, Universal, Variable, to name a few.

They are permanent because, unlike term life which covers a fixed number of years, permanent policies are structured to last a lifetime.

I’ve promised to spare you from drowning in a sea of details, so I want to narrow these down to a basic choice between term life and whole life insurance.  If your goal is to protect your family for very long periods of time or to substitute for a closing of your business or to pay for estate taxes after your death, you’ll want to look into whole life or universal insurance. If you are primarily concerned with protecting your family from the loss of income that would result from your death, during your working years, a term life policy makes more sense and is significantly easier to pay because the premiums are much lower.

How Much Life Insurance Do You Need?

Let’s turn to the question of how much insurance you need.  Some advisors throw out a generic recommendation of 5, 10, or 20 times your annual salary, but you’d be well served to look closer at your finances and your family’s particular needs before deciding on an amount.

For starters, add up all your unpaid debts, your mortgages, your credit cards, your loans as those will be directly deducted from the insurance proceeds.  If you think you’re going to add on more debt over time, you’ll want to buy more insurance to cover it.

The next factor—in some ways the heart of the issue—is replacing the loss of income that you’re no longer providing for your family.  What will happen is that the insurance proceeds will be invested in assets that will generate some income for your dependents to live on and also cover future one-off obligations like college tuition.  At this point, you probably want to err on the side of a slightly more generous level of income to guard again inflation.

Figuring out how much the insurance payout must be to generate enough income is tricky because of the volatile nature of investments.  In order to arrive at the size of the insurance payout you need, you have to make a reasonable assumption about the average annual returns its investments would earn.  A range of 5-8% is generally a good rule of thumb, but your return could be much lower. To give a very simplistic example, let’s say you were earning a salary of $80,000, had no debt, and no future one-off obligations, and you want to replace all of that income for your dependents.  Assuming that even if your insurance benefit money is invested in assets that may earn 6-8% over a very long period of time, taking 3-4% of your assets annually may increase the probability of your money lasting a longer time.

Dividing $80,000 by 4% and you’ll find that you need $2,000,000 in insurance.  This income-based method of estimating is very simple and I only mention it to give you a starting point to get a handle on what you may need. The true numbers require more sophistication and more specific modeling of returns based on different types of investment mixes. Financial planners, insurance advisors, and online insurance calculators should be able to h

Bottom Line: It’s All About Your Family’s Needs

Another way to think about the question of how much insurance you ought to purchase is through the “needs approach.”  There are two main components: first, how much money will be needed at death to pay for obligations like funeral expenses, legal fees, mortgages, and business buyout costs, among others.  Secondly, how much future income will be needed to sustain your dependents?

If you’re not sure how much income your dependents will need, it can help to get a better handle on your current household spending and saving. Personal budget software can make this estimating easier and more accurate.  If you’re saving consistently and are on target for your retirement goals, you may not need as much insurance.  On the other hand, if you want to make allowances for special expenditures like college or a new car for your spouse, you may need more coverage. Depending on the specifics of your household, your family may not need to maintain all of the monthly costs you’ve been paying, and some items like your health and auto insurance bills can be dropped.

Don’t Buy More Life Insurance Than You Have To

You’ll want to total up all your existing savings and investments so that you can subtract them from the amount of insurance you’ll need. Also, don’t forget to add in any income your spouse brings in. There’s a very good chance that your spouse will be eligible for Social Security survivor benefits, and don’t forget any life insurance policies you have through your employer.

So, the difference between all these resources and your family’s needs provides a good approximation of how much insurance you should buy.  Online insurance calculators can help you make a thorough inventory of these resources and offset them against your life insurance needs.

Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph, or marketing piece to make decisions. The information contained herein is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice.  Please contact your financial advisor with questions about your specific needs and circumstances.  There are no investment strategies, including diversification, that guarantee a profit or protect against loss. Past performance doesn’t guarantee future results. Equity investing involves market risk, including possible loss of principal.  All data quoted in this piece is for informational purposes only, and author does not warrant the accuracy, completeness, timeliness, or any other characteristic of the data. All data are driven from publicly available information and has not been independently verified by the author.

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Steve Pomeranz
I've been an investment strategist and adviser for over 35 years, leading with a mission of unbiased advice to educate and protect listeners on my weekly radio show on NPR affiliates nationwide. I have been named a “Top 100 Wealth Advisor” by Worth Magazine and “Top Advisor” by Reuters.