When I was a young husband and father, I visited an old family friend who had been in the insurance business for ages. Being concerned about the future, I asked, “How much life insurance do I need?” The old pro looked at me and replied, “How long are you planning on being dead?”
I subsequently discovered that there are popular rules of thumb used to calculate the amount of life insurance you need (8 to 10 times your annual income is typical). I also learned that each person’s situation is different, and needs to change over time. As a consequence, you should assess your situation and your life insurance need each time a major event in your life occurs, such as a marriage, birth, home purchase, new business, death, or retirement.
How to Determine Your Life Insurance Needs
To get a rough approximation of your insurance need, consider the following:
1. Determine the Ideal Amount
- Multiply your annual after-tax income by the number of years you expect the need to exist. For example, your spouse might need an after-tax income of $40,000 until retirement 40 years hence, or $1,600,000 in total.
- Add the costs of major events (e.g., children, college, major future purchases). Continuing the above example, $1,600,000 of spousal need plus $500,000 for children would total $2,100,000.
- Deduct the value of the net assets (assets minus liability) you own. For example, if you have $100,000 in assets, the $2,100,000 amount calculated in the previous step would be reduced to $2,000,000.
- Determine the present value of the sum using a present value table or a financial calculator with 2.0% as the interest rate. The present value is how much you would need to invest today to arrive at your calculated future need. A growth rate of 2.0% each year is both conservative and realistic given historic investment performance and inflation.
2. Calculate How Much You Have Available for Premiums
Determine how much premium you can afford to pay presently, as well as during the term, after paying for other necessities like shelter, food, clothing, transportation, and health insurance.
3. Solicit Quotes From Multiple Insurance Providers
Be sure that you understand the underwriting requirements, and get quotes from at least three providers. For example, if you are a smoker, get the costs of a smoker policy rather than relying upon the advertised premium or what a nonsmoker with ideal health would pay. In the example above, a nonsmoking 25-year-old male in good health would probably pay a premium between $1,500 and $2,000 per year for $910,000 of term insurance.
4. Select the Optimum Owner to Purchase the Policy
While you are the insured life, the policy owner can be a trust, your spouse, or anyone else who has an insurable interest in your life. You must be sure you understand the tax aspects of any insurance proceeds to your beneficiaries upon your death. For example, the ownership of the policy could be held by the other spouse, thus avoiding estate taxes on the insurance proceeds which would be due if the covered spouse is also the owner of the policy.
There are legal requirements to ensure that the proceeds remain outside the estate, however. It is always wise to consult an estate planner or attorney when dealing with end-of-life issues.
Typical Coverage Amounts
With that process in mind, here are examples of a typical person’s needs of insurance coverage over a lifetime:
Pre-Marriage and Children
Young adults and married people without children usually don’t have a major need for life insurance. Other than funeral costs and payment of college loans and consumer debts, obligations are minimal. If both marriage partners work, don’t own a home, or accumulate significant debt, there is little need to buy insurance to protect one’s earning power since the survivor is likely to continue to work. In addition, a young surviving partner is likely to remarry. The amount of life insurance needed is usually less than $50,000 for either partner.
Purchase of a House or Incurring Major Debt
If you are single and no one else is obligated on the debt, the asset can be sold and the proceeds used for payment. If you are married and wish the asset to remain intact, the amount of insurance needed would include the remaining balance on the debt.
For example, if your mortgage is $200,000, your need would be $200,000. As the mortgage is paid off, the amount of insurance needed would decrease. However, you should consider the continuing cost of house insurance and taxes in your everyday living expense. Insurance for someone in this position probably ranges between $400,000 and $600,000.
According to a recent study by the U.S. Department of Agriculture, the average cost of raising a child born in 2010 to age 18 is $226,920. College costs another $21,447 per year at an in-state public university. Again, the need for insurance to cover these costs decreases as you continue to live, work, and save. Initially, you might need approximately $300,000 in coverage for a newborn (including projected college costs); however, that cost reduces each year of the child’s life.
Remember, insurance is intended to provide the income you are not able to provide due to an early death; it is payable only if you die. A separate savings element, possibly in the form of the accumulated cash values in the insurance policy, is needed to cover such expenses if you’re alive. People with children should have a minimum of $200,000 per child in life coverage in addition to their other needs.
Starting a Business
Whenever a business owner dies, an estate tax is due. Life insurance is one way to provide liquidity when it is needed – unless you are prepared to sell the business.
If you’re in a partnership, all business partners will want to fund a buy-sell agreement with insurance. This ensures that they do not have to cover the costs of company obligations borne by the partner, and that they have available cash to purchase the deceased partner’s interests in the company from his or her heirs.
This type of coverage can be accomplished with joint life insurance with first-to-die coverage. Due to different legal and tax questions, this insurance need should be covered in a separate policy with different owners than insurance purchased to buy family security.
Death and Estate Taxes
By the time most people reach retirement age, there is little need for life insurance unless the person has a substantial estate (well above $1 million under current tax laws). In that case, especially when the assets may be difficult to sell or would require a hardship by the beneficiaries, many individuals keep life insurance in place solely for its liquidity value. If your estate is in this category, visit an attorney for a complete estate planning exercise – it will pay for itself in saved taxes.
In the hustle and bustle of everyday life, we sometimes forget our financial responsibilities to our families and business partners. Owning life insurance is an act of love and provides peace of mind that our loved ones will not have to endure the loss of a spouse or parent with the additional burden of financial strife.
Why else do you believe life insurance should be purchased? Have you ever experienced an instance where the proceeds of a life insurance policy ameliorated the stress of an unexpected loss?