People buy life insurance policies for a slew of reasons. But policyholders generally have the same broad goal in mind: ensuring their death doesn’t create an undue burden for those left behind.
That burden can take many different forms. And, of course, one individual’s death can create multiple types of burdens, from the loss of sorely needed household income to lingering debts that could be far more difficult to manage without them around.
If you’re wondering whether you need life insurance, the answer is probably “yes.” Two better questions to ask are how much life insurance you need and why you need it. Let’s drill down on the second.
Common Reasons to Buy Life Insurance
Whether they choose a permanent cash value policy like whole life insurance or universal life insurance, or a temporary term life insurance policy that expires worthless if the policyholder outlives the term and doesn’t renew, these are some of the most common reasons people buy life insurance.
Many policyholders have more than one reason for purchasing a life insurance policy, and any given policyholder’s specific mix of reasons for carrying coverage can change over time.
1. Settling Final Expenses (Funeral Expenses and Related Costs)
According to data compiled by the National Funeral Directors Association, the average cost of a funeral with viewing and burial exceeded $7,500 in 2019. The average cost of a funeral with viewing and cremation was only slightly lower, clocking in at over $5,000.
It’s certainly possible to pay less than $5,000 for your send-off. But it’s also challenging to put a price on that final goodbye, particularly when it’s done less for your benefit than to provide closure for grieving loved ones.
Despite their low relative cost, don’t forget to include your estimated final expenses in your initial life insurance calculation. Failing that, you could feel compelled to purchase final expenses insurance much later in life. Final expenses insurance, a form of term life insurance with a small death benefit (payout) specifically designed to cover final expenses, tends to be much more expensive than standard term life insurance purchased earlier in life.
2. Paying Off Major Debts
When calculating your life insurance coverage needs, account for any outstanding joint debts held with your spouse or other relatives. That includes any home loans, auto loans, personal loans, and credit cards held in both your and your spouse’s name. It also includes any debts cosigned with a relative other than your spouse or an unrelated friend.
And don’t forget to account for any outstanding or expected debts that can’t be discharged in death. Although most types of debt don’t fit this description, some common obligations do. For example, unlike public student loans, which don’t survive the borrower’s death, some private student loans become the responsibility of the original borrower’s heirs.
If you’re married and live in a community property state, your life insurance needs could be higher than you realize. Nine states have mandatory community property laws: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
Under community property law, spouses are liable for any debts initiated during the marriage, even if they’re not officially a joint account holder. That means you’re responsible for your spouse’s outstanding credit card, car loan, and personal loan balances — among many other types of debt — if they die before you and vice versa.
You need at least enough life insurance coverage to pay off these outstanding debts in full, plus a buffer to cover prepayment penalties and housing expenses that outlive your mortgage payoff, such as property taxes and insurance.
3. Covering Expenses Indirectly Attributable to the Policyholder’s Death
No one can blame you for the financial strain caused by your premature death. But you can’t ignore it either.
Your life insurance coverage calculation must therefore include expenses that wouldn’t burden your spouse if you were still alive. Such expenses often arise from the loss of the deceased’s labor and the corresponding increase in demand on the surviving partner’s time:
- Child care for younger children so your spouse can continue to work full-time or increase their hours worked
- Part-time child care for school-age children so your spouse can work productively
- Home cleaning and maintenance services (such as landscaping) you or your spouse would previously have done personally
- Health insurance for your spouse and children if they previously had coverage through your employer and your spouse’s employer doesn’t offer adequate coverage
The total amount of life insurance needed to cover indirect expenses resulting from your death depends on what expenses you expect to incur and for how long. For example, if you die when your kids are ages 1 and 3, you need about two years of full-time child care for the older one and four years for the younger one before they begin attending elementary school during the day. At $15,000 to $25,000 per child per year, that’s anywhere from $90,000 to $150,000 over four years.
4. Providing for Expected Future Secondary and College Education Expenses
Because your chances of living to see your kids graduate from college are good, you can plan to pay for their education out of your savings. However, your premature death could — and probably would — create unanticipated expenses hefty enough to knock your financial plan off course. If that happens, whoever assumes responsibility for the significant financial obligation that is your kids’ education needs to be able to pay for it.
The easiest way to ensure that is to carry enough life insurance to cover expected education costs for each of your children through their undergraduate years. Use a college savings calculator like the free one at Saving for College to game out multiple scenarios. Then assume something close to the financial worst case: that all your kids (or expected future kids) attend private, four-year universities with no financial aid.
5. Maintaining Survivors’ Standard of Living
Your premature death shouldn’t strain your survivors. Aside from the gaping hole you no longer fill, the hope is that they’re able to continue their lives and plan their financial futures more or less as before.
That means they’re not required or compelled to make significant lifestyle changes, such as selling the family home or living without a car. Ideally, they’ll be able to maintain the same standard of living (with the about the same living expenses) as before — meaning the ability to take a weeklong vacation every year or dine out once per week or even keep the second home you acquired together.
Protecting your survivors’ standard of living means replacing most of the income lost to your premature death in addition to covering major debts, future educational expenses, indirect expenses, and other financial obligations that could burden your survivors. That’s an expensive proposition. It’s your current annual income multiplied by the number of years before your expected retirement date multiplied by a flat percentage to account for inflation.
In reality, your overall life insurance needs decrease as you pay off debts, accumulate wealth, and realize more of your expected lifetime earnings, so you don’t need to replace every dollar of income forgone if you died tomorrow. However, if you’ve been fortunate in life, you’ll need to maintain enough coverage later in life to ensure your survivors’ inheritance isn’t slashed by estate taxes after your death.
To keep your monthly premiums manageable and ensure you’re not continuing to pay for coverage you no longer need, use a life insurance ladder. This strategy offers a way to step down coverage over time using multiple policies with different term lengths and death benefits.
6. Protecting Business Interests That Will Outlive You
If you own interest in a corporate entity with a business partner or partners, you need to entertain the scenario that your death could threaten your company’s continued existence.
That isn’t only because your expertise is irreplaceable in the short term. It’s also because, as a business owner, you bore a significant portion of the company’s operational costs. And most people’s spouses probably aren’t qualified to assume their duties. Even if your spouse is your business partner and fully qualified to do your job, they can’t singlehandedly do the work two people previously did.
For these reasons, your business partner needs you to have what’s commonly known as a key person insurance policy — an insurance policy on your life with your business partner as the named beneficiary. You need a similar policy on your partner’s life, with you as the designated beneficiary.
These policies’ death benefits must be high enough to cover operational expenses in the near term and provide adequate liquidity for the surviving partner to buy out the deceased partner’s heirs as part of your company’s buy-sell agreement.
7. Tapping Your Policy’s Cash Value During Your Lifetime
Like real estate investments, permanent life insurance policies build equity over time. If you have permanent life coverage, you have the option of tapping that equity to cover essential or discretionary expenses as you see fit. Indeed, because permanent life insurance holds value better than more volatile asset classes like stocks, it’s a valuable source of liquidity when money is tight.
Some people mistakenly believe that life insurance is a scam. This is because the money for premiums is lost if death doesn’t occur during the coverage period (in the case of term insurance), or because many people live to a ripe old age and continue to pay their permanent insurance premiums. Such naysayers compare life insurance protection to gambling, and forgo the protection entirely.
Of course, there is no bet — you will die, but no one knows when. It could be today, tomorrow, or 50 years in the future, but it will happen eventually. Life insurance protects your heirs from the unknowable and helps them through an otherwise difficult time of loss.