How much life insurance do I really need?

April 26, 2018

Ask your spouse how much life insurance you need, and he or she will say, how much can you afford. The reality, though, is none of us have unlimited funds. You don’t want to waste money on too large an amount, so there are several ways to think about and calculate the correct amount for your family.

You want to approach insurance need from a real mathematical perspective, and avoid so called “rules of thumb” that insurance agents use love to use as easy methods of convincing you to make a purchase from them. Many insurance agents, when asked for assistance with determining the right death benefit amount, well tell you things like, “you should spend 6% of your gross pay on insurance premium.” Really, what does that have to do with providing for your family? All you have accomplished is you are now spending 6% of your pay on some unknown amount of protection.

No one can truly tell you what your family need is, especially based on pre-determined “rules of thumb.” Here’s a scenario, you are the breadwinner of the family and are concerned about what happens to your husband and two children upon your premature death. So you discuss the need with your husband and in the process his parents remind you that he is from a wealthy family and will be provided for if your income disappears. Rules of thumb won’t bring these types of situation up, only open discussions with all of those involved.

Determining death benefit based on estimated total future need

The easiest and in my experience the most common method of determining insurance need is to simply add up all of the family’s current and future liabilities. As a financial planner, one of the biggest requests I received for life insurance was a death benefit amount equal to a recently issued mortgage. If you just purchased a home and have borrowed $300,000, you want to make sure your family can keep the home if you die, so you purchase a $300,000 death benefit for 30 years.

It’s important to remember, though, that needs change over time. The mortgage balance reduces every year so in the 29th year, do you really need $300,000 in protection? You could purchase a reducing term, or you could just be happy with the fact that you are over protecting your family and that is not necessarily a bad thing.

As simplistic as the future need method seems, its simplicity is what give people peace of mind. They know exactly what they are protecting and the know their family will be cared for. Its easy, add up all the future expenses you would be leaving behind, mortgage balance, education funds for kids, a new car for your spouse every 5 years, and cover for your current debts and final funeral and other costs.

Determining death benefit based on monthly income replacement requirement

Rather than adding up arbitrary future costs of which any number you come up with is going to be a wild guess, another method you can use is to determine the amount of income you would like to leave your spouse.

Let’s say you and your spouse are both 40, you make $100,000 a year and your spouse makes $40,000 a year. If your income is gone tomorrow due to your premature death, how much income will your spouse need to maintain the family’s current lifestyle?

It’s not that complicated, really. Insurance proceeds are tax free, earned income is taxable, so $100,000 a year in earned income is the equivalent of about $70,000 in annual income after tax at a tax rate of 30%. Now, because you are gone, the family’s total expenses probably go down a little – you’re not eating any more, you don’t need a car, you are not using electricity, etc. Additionally, if you have unmarried children under the age of 18, they will receive social security benefits. So, taking all of that into account let’s say you decide you want your surviving spouse to receive $50,000 a year.

Next, how long does the spouse need those funds? At age 40, he or she will be at or close to retirement by age 70. The income you provided should have been enough to continue making mortgage payments so the mortgage is paid off. Kids are now grown and on their own, and your spouse’s retirement should be set since the income provided allowed him or her to continue making normal retirement contributions. So, bottom line, your goal is to provide $50,000 a year in income, or $4,200 a month, for 30 years. Now go to the chart below.

Find the correct dollar amount you want to provide monthly, and trace over to the number of years. In this example, you are looking at a death benefit amount over between $831,000 and $1,039,0000.

Other considerations

Here are a few other things to consider. Does your employer or work benefits package provide any type of survivor benefit? What type of family support would your surviving spouse receive? Is it important to you to allow your family to continue at their current lifestyle, or do you also want to leave even more as a legacy to your children, maybe to benefit your future grandchildren? There are so many considerations, just get a piece of paper about, start listing them down, and discuss with your spouse.

It’s important to not get caught in wanting simple answers to complex questions. Rules of thumb can get you in trouble. Spend the time and don’t rush into any decisions. If your insurance agent tells you that you need to make a quick decision because the deal being offered is only available for a limited time, find another agent.