September 8, 2018

How Much Life Insurance Do I Need?

Read more about Life Insurance

How much life insurance do you need? This depends on your income replacement needs, your current debt, and future plans. We break it down.

Life insurance is a useful tool for managing risk if something were to happen to you.

First, you need to know whether you need life insurance. You may have more than one reason to buy life insurance.

Thinking about your own death and how it'll impact your loved ones is scary. To make it easier, you can imagine a hypothetical family and what they should do under the same circumstances.

We've made up a family for this discussion. Let's say Pat (the husband) wants to provide for his family. Kendall is the surviving spouse. They have two young children, ages 3 and 7.

We'll walk through questions we should consider when determining how much life insurance Pat needs.

  • Life insurance is a good idea if: You have anyone in your household who will suffer financially if you died. Life insurance will allow you to provide for your loved ones after death.

  • You may not need it if: You have no dependents at all. Possible scenarios could be if you're a retiree with no spouse or children, or if you're a young single person with no plans for a family.

Income Replacement Needs

How much income replacement is needed is different for every family. Here are some questions to consider:

  • What income would Kendall have if Pat died? (Consider income from work, Social Security Survivor's Benefits, and investments.)

  • What is Pat's income (after taxes)?

  • How much are Pat's personal expenses?

  • For how long would Kendall need income replacement? For the rest of her life? Or only until the children graduate from college?

  • If Pat dies, would Kendall work or would she want to stay home with the kids?

  • Would Kendall want to relocate closer to family for support if Pat dies? Would the relocation be to a more expensive area like California or to a less expensive area like Oklahoma?

Whether the family would need ALL of the income Pat provides varies from person to person. Some people spend a lot of money on expensive hobbies; that money is no longer needed once they are gone. If Pay's hobby is scuba diving, the family won't need as much income because that's an expensive hobby.

Other people contribute unpaid labor to the family that must be provided in another way if they die. If Pat does the gardening and home maintenance, Kendall will either have to do those tasks herself or hire someone to do them. What would it cost to pay someone to do the tasks Kendall won't do?

It's important to know exactly how much the surviving family will need each month. See how much your family spends a month on average. This will give you an idea of how much life insurance you really need to get.

We'll get into some calculations later.

Debt Repayment

Besides just replacing income, you also need to consider how much existing debt there is. Think about:

  • Should Pat leave enough to pay off the mortgage?

  • Does Pat have unpaid student loans?

  • Does Pat have other debts to pay off (medical debt, credit card debt, etc.)?

  • Does Kendall also have student loans?

If you have debt, it's smart to buy more life insurance so they can be paid off. This way, the surviving spouse won't have to choose between using the money for living expenses or to pay off debt.

Children's Education

Another reason people use life insurance is to leave enough money for their children to attend college. Think about:

  • Do Kendall and Pat want to pay for the children's college expenses?

  • What is the estimated cost for a state or private university?

  • Would they want to fund living in a college dorm or a semester abroad?

If you're already saving for your kids' college out of your income, then you shouldn't need more beyond income replacement. If you don't have any savings yet, then you can consider taking out more to cover the kids' college educations.

Retirement Needs

  • How much money do you need to retire?

  • Would Kendall be able to save for retirement without Pat's income?

  • Would Kendall's retirement income be enough without Pat's?

If Kendall doesn't work and has no retirement savings, then Pat may want to take out enough insurance to provide income for the rest of Kendall's life.

Let's say Kendall will continue to work and will have enough retirement income from pension, Social Security benefits, and investments. Then maybe Pat only needs to get a term insurance to replace his income until the children are out of college.

Other Cash Needs

Here are some other things to think of:

  • What would Pat's funeral cost? The average cost of a funeral is around $10,000.

  • Does Pat want to provide an emergency fund for Kendall and the kids?

  • What if they haven't bought a house? Does Pat want to provide enough so Kendall can buy a house?

Other Special Situations to Think Of

Families are unique. The earlier questions are common issues for most families. The following less common special situations have the potential to have a large influence on the amount of life insurance.

  • If you have a special needs child who will require lifetime care.

  • If you have an estate and will need to pay estate taxes.

  • If you have a business and you want to make sure it can survive after you're gone.

  • If you're an unmarried couple and wish to provide for each other.

  • If you have children out of wedlock that you wish to provide for.

If you have a special needs child, that's a special case. Most likely, you will have to provide enough for the child to receive care for the rest of his/her life. In this case, permanent life insurance is the best option. Many parents with a special needs child buy large life insurance policies and establish a special needs trust.

Determining How Much Insurance Is Needed Based on Income

Once you figure out how much income, debt repayment, and other cash needs must be covered, the amount of life insurance needed can be determined.

There are two standard methods of determining how much insurance you need for income replacement.

  • Replacing Income for Life: 4% Guideline.
    For lifetime income replacement, here's a quick way of calculating how much life insurance to take out.

    Let's say Pat and Kendall figure out that Kendall and the kids can live on $4,000 a month. This is equal to about $50,000 a year. So Pat would want to provide an annual income of $50,000 for the rest of Kendall's life.

    One rule of thumb is the 4% guideline This assumes that the lump-sum payout will earn a 4% return each year. Kendall and the kids can live off of the interest. So in order for them to get $50,000 a year, the calculation would be:

    $50,000 / 4% = $1,250,000 ($1.25 million)

    Kendall would get $50,000 every year until death and $1,250,000 would be available for the kids to inherit. With this method, it's very unlikely that Kendall will run out of money.

  • Replacing Income for a Certain Period.
    What if you don't need to replace income for life? Maybe the surviving spouse has the ability to go back to work. Or you only need income replacement until you can collect retirement investments.

    Let's say Pat and Kendall decide to only replace income until both kids have graduated college. The youngest is 3, so that's in about 20 years. The question is, "How much money do I need to provide an income of $50,000 per year for 20 years?"

    It's not just $50,000 x 20, because the money will earn interest.

    We need the help of an online calculator, such as this one. Using the same 4% return assumption, the amount needed to provide $50,000 per year for 20 years is $679,517.

    With this method, at the end of twenty years, the $679,517 is gone.

    If you want to provide some cushion against unexpected events, you can take out a little bit more. This way, at the end of 20 years, there's still a small lump sum remaining. So, for example, you can take out $750,000 total.

How Much Life Insurance Total?

Now let's say Pat and Kendall have debt and other needs besides just income replacement. Let's assume Pat wants to provide for 20 years of income. Here's what their list looks like:

20 years income replacement$679,517
Mortgage remaining$200,000
Pat's student loan debt$15,000
Kendall's student loan debt$15,000
Children's education (2 kids, 4 years each)$240,000
Pat's funeral expenses$10,000

In total, it would be smart for Pat to take out $1.16 million of life insurance. This would ensure that Kendall can properly bury Pat, pay off their debts, send the kids to college, and have enough to live on for 20 years.

You also need to subtract what you already have. For example, if Pat and Kendall already have $40,000 of cash savings, subtract it from the $1.16 million.
If you are providing lifetime income, you would subtract Pat's 401(k) as well.

Bringing It All Together

Life insurance can help you manage many of the risks your family would face if you die prematurely.

After you calculate how much income you'll need, add that amount to any immediate cash needs. Some of the lump sum needs may not need to be fully funded because the money has time to grow.

The kids' college fund and Kendall's retirement account have time to grow. Or you can fully fund them with the idea that the earnings provide a hedge against inflation.

Steps for Determining Coverage:

  • Decide what you want for your loved ones if you are no longer here.

  • Decide how long to provide income for your survivors.

  • Figure out how much the surviving family needs to live on per month.

  • See what the immediate cash needs are (funeral expenses, debt payments, etc.).

  • Consider the long-term needs (children's education, retirement savings, etc.).

  • Subtract any savings you already have.

  • Calculate your total life insurance needs.

  • Take action to protect your family.

Disclaimer: Opinions expressed here are author's alone. Please support CreditDonkey on our mission to help you make savvy decisions. Our free online service is made possible through financial relationships with some of the products and services mentioned on this site. We may receive compensation if you shop through links in our content.

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