How Much Life Insurance Do I Need?

By October 1, 2019 Blog No Comments

Life insurance is a pretty big deal. It is definitely something that should be a priority in your life because it will benefit you and your loved ones. If you’re wondering about life insurance and are questioning how much you need, then we have some answers for you. 

The bottom line is this: how much life insurance you need depends on your overall needs. You probably won’t be able to pinpoint the exact amount of life insurance you should buy down the penny, but you can definitely make a good estimate. In order to do this, you must consider your current financial situation and imagine what your loved ones will need in the upcoming years. 

Basically, you should find your ideal life insurance policy amount by calculating your long-term financial obligations and then subtracting your assets. The gap is what your life insurance policy should fill. But, it can be really tricky to know what to include in your calculations. There are a number of ways to look at this situation. Let’s look at a few of them. 

Rule of Thumb #1: Multiply Your Income By 10

This isn’t a bad rule at all, but based upon our economy today and our interest rates, it’s definitely an outdated rule. It doesn’t take a detailed look at your family’s needs, and it doesn’t take into account your savings or an existing life insurance policy. It also doesn’t provide a coverage for parents who stay at home. 

Both parents should always be insured, because the value that is provided by the stay-at-home parents needs to be replaced if he or she passes away. If only bare minimum was provided, the remaining parent would need to pay someone to provide the services, like the child care that the stay-at-home parent provided for free. 

Rule of Thumb #2: Buy 10x Your Income and $100,000 Per Child for College Expenses

Education expenses are a really important aspect of your life insurance calculation if you have children. But, like the previous method, this method doesn’t look at your family’s needs in detail and doesn’t consider any existing life insurance plan. By just buying 10x your income, you aren’t really looking at the big picture or planning ahead much. 

Rule of Thumb #3: The DIME Formula

This formula is a better option because it makes you take a more detailed look at your finances than the previous methods. DIME stands for debt, income, mortgage, and education. These are four areas which you need to consider when calculating how much life insurance you need. 

For this method, you will need to add up your debts that don’t include your mortgage. Plus, take into consideration what funeral expenses will add up to. 

Then, decide how many years your family will need support. Your annual income should be multiplied by that number. Just as an example, the number of years might be how long before your youngest child would graduate from high school or college. 

You will then want to calculate the amount of money you need to pay off your mortgage and estimate the cost of sending your kids to college. 

This formula is definitely more comprehensive than the other two, but again, it doesn’t account for the life insurance coverage and savings that you might already have. It also does not take into consideration the unpaid contributions of stay-at-home parents. 

The Bottom Line: How to Find Your Best Number

To calculate your target coverage amount, you should take your financial obligations and subtract your liquid assets. To calculate your obligations, add your annual salary times the number of your you want to replace income to your mortgage balance and your other debts. Also add in future needs like college and funeral costs. If you are a stay-at-home parent, then you can also add in the cost to replace what you provide for your child. 

From this number, subtract liquid assets like savings, college funds, and current life insurance. This is a very sure way to calculate how much coverage you will need in the long run. 

Some tips to keep in mind when calculating your coverage needs: 

  • Don’t plan life insurance in isolation. You should consider this purchase as a large part of your overall financial plan. 
  • Don’t skimp on the coverage. You should always buy a little more coverage than you think you’re going to need, instead of buying less. Always remember that your income will probably rise over the course of time, as will your expenses. You might not be able to anticipate how much either of these will increase, so a cushion will help ensure that your spouse and kids can maintain a happy lifestyle. 
  • Talk through the numbers with your spouse. Ask your spouse how much money he or she thinks your family will need to carry on without you. Do your estimates match up? Figure out if your family would need to replace your full income or just a portion of it. 
  • You should consider buying multiple, smaller life insurance policies instead of one large policy. This will help vary your coverage as your needs increase and decrease. For example, you could buy a 40-year term policy to cover your spouse’s needs until retirement, and then also buy a 20-year term policy to cover your children’s needs until they graduate from college. 
  • If you are the parent of a young child, then you should choose 30-year terms over 20-year terms to give them time to build up assets. With a longer term, you probably won’t get caught short, and you won’t have to shop for coverage a second time when you’re older and rates are higher. 

Planning Ahead for Final Expenses

Most of us are familiar with the idea of planning for our final expenses. This might not be something you necessarily want to think about, but it’s something that needs to be done. There are aspects of life insurance that cover mortuary and funeral-related costs. Sometimes, this is called burial insurance, or memorial insurance. 

Some policies will allow you to choose a funeral home or service provider. This means that you can make arrangements in advance and free your family from making some of those really tough decisions. And of course, this means that you can keep track of the costs more closely. 

Burial insurance takes away some of the stress of wondering how you will pay for your final expenses, and also eliminates debt for your surviving loved ones. Also, by taking away this stress for your family, they will be able to spend their grieving time remembering your wonderful life and how much they love you. 

Telling Your Family

Taking the initiative to purchase a life insurance policy with a burial insurance option is great because it will take away so much stress for your family. But, it might be hard to tell them about this. It’s a tough subject to address. 

Once you have everything figured out, just simply mention it to your spouse or other close family. It will also help to have some written instructions including any funeral homes or mortuaries that you have contacted that accept your life insurance policy. Be sure to write down your insurer’s name along with your policy number and benefit amount, in case of any outstanding loans. Also tell your spouse and other close family members when all of the original documents are so they will be able to locate them when the time comes. 

Don’t Pick the Cheap Option

One of the most common reasons people buy life insurance is to pay off major bills and debt, like a mortgage. 

When people look at life insurance policies, they are often tempted to choose the cheapest one. But, this policy might not meet your needs and it might not provide the  best coverage. The “term” for your life insurance policy is the amount of time that your rate and coverage are guaranteed for. Terms usually range from 10 to 30 years. Inexperienced insurance shoppers are very attracted to low premiums in a short term policy, but this strategy isn’t a good one. 

Why? 

This is a poor strategy because life insurance gets more expensive with age. You will never be healthier than you are at an early age, and you definitely won’t get any younger. Life insurance is always based off your mortality risk, and this increases as we get older. 

Age, overall health, and weight are key factors in determining insurance premiums. If you lock in a renewable insurance policy early on in life, then you are way better off. 

Most life insurance companies offer fixed rates up to 30 years on term policies. This is fantastic because this means that once your policy is established, your premiums will be fixed for 30 years, no matter what changes you go through. If you pass away during this time, then your loved ones will receive the face-amount of the policy, with no tax deductions. So, this policy might cost you more right now, but in the long run, it will definitely save you money, even if your health does not change. 

The only time when buying a shorter term policy might make more sense is if affordability is truly going to be an issue. Term life insurance is really flexible with fixed rate periods that are as short as one year, with an annual renewable term. But, the most effective term policies usually end up being about 10 years. 

Your debt won’t affect your loved ones if you plan accordingly.

You have a ton of options when it comes to determining what to do with your life insurance policy. You might want to designate the proceeds to pay off debt against your property so your loved ones remain stable after your death, or you might want to provide your loved ones with available cash when the time comes. Either way, your beneficiaries will not have to pay off your debt if you plan accordingly. 

Your estate 

Basically, your estate is responsible for any debts that you leave behind when you pass away, regardless if they’re secured or unsecured. If you cannot pay everything off before your death, your creditors can make claims for what you owe against your estate. Usually, the only way your life insurance proceeds would pay off these debts is if you name your estate as the beneficiary. You can do this if you want to avoid having your executor liquidate assets to cover taxes and other liabilities. In most states, creditors only have a limited amount of time in which such claims can be made. If they do not take action before the deadline, then your estate won’t usually owe them anything. 

Your beneficiary 

If you give a family member the title of beneficiary for your estate, then the death benefits avoid probate. The probate process needs to happen in order to transfer ownership of your assets after your death, but a life insurance policy is a contract with your insurer that requires them to pay the proceeds to a certain individual or many individuals. So, the policy doesn’t require probate, which means that your creditors don’t have access to the proceeds. They legally cannot make a claim against your beneficiary. 

Exceptions 

Typical rules have exceptions when co-debtors are involved. For example, if you and your spouse are jointly liable for a certain debt, then he become responsible for the whole debt when you pass away. You both would have needed to sign a contract with the lender at the time you took the loan, which means that you both agreed to be responsible for paying it. If one of you cannot follow through with this, then the creditor can absolutely look to one of you or the other for payment. This remains true whether or not you name your co-debtor as beneficiary of your life insurance policy. But, if you name your estate as your beneficiary, then your estate has the option of paying off the balance so your spouse doesn’t have to in the future. 

Other options 

Living trusts bypass probate, which is what assets do when they pass to beneficiaries through a contract. If you decide to name your trust as the beneficiary of your life insurance policy, different rules will probably apply, but they might depend on your state’s specific laws. 

You can also create a life insurance trust in order to avoid leaving the ultimate decision up to the court system. Life insurance trusts cannot be changed. All you can do it transfer the ownership of the policy to the trust, or create the trust and then direct the purchase policy. Either way, the trust is named as beneficiary and its assets are off limits to creditors. You can then set up your trust to transfer the death benefits to the beneficiary of your choice. And, the best part is, your creditors cannot have the proceeds. 

Myths 

There are some really common myths about life insurance that people get easily sucked into. Don’t believe something that isn’t true–take a look at these myths so you know what to avoid. 

1. I’m single and I don’t have dependents, so that means that I don’t need coverage. 

This is downright false because everyone needs coverage. Even single people need enough life insurance to at least cover the costs of personal debts, medical expenses, and funeral bills. If you’re not insured, then you might leave some unpaid expenses for your family or an executor. 

2. My term life insurance coverage at work is enough. 

This could be true, but probably not. Only in rare circumstances does employer-paid term coverage meet an average person’s needs. If you have a spouse and you know that he or she will need coverage upon your death to pay estate taxes, then it would be a smart move to purchase additional coverage. 

3. My life insurance coverage needs to be only twice my annual salary. 

The amount of life insurance each individual person needs depends on each person’s specific situation, and there are so many factors to consider. Aside from medical and funeral bills, you have your own individual debts to pay like your mortgage and your vehicles. 

4. The cost of my premiums will be my deductible. 

This is false in almost all cases. The cost of personal life insurance is never deductible, unless the policy holder is self-employed. 

5. I’m better off investing my money than buying life insurance. 

This is absolutely false. You are going to need life insurance of some sort. Investing money is not going to provide you with coverage for yourself and your family. If you die without any kind of coverage, this will be a nightmare for your spouse, children, and other family members. 

So, what life insurance policy is right for you? 

As you can see, there is so much to think about when it comes to life insurance. But, if you take things step by step, you’ll find the right policy for you. 

About Woven Capital

Aaron Hatch is a Certified Financial Planner and co-founder of Woven Capital, a fee-only financial planning and investment management firm that specializes in helping people balance life, work, and community. Aaron has been quoted in various publications, including The Chicago Tribune, US News and World Report, and the Huffington Post among others. Aaron can be reached at aaron@wovencapital.net