Jeff Rose at Good Financial Cents is putting on the Life Insurance Movement, and this post is a part of that. Be sure to read all of the other life insurance items and enter yourself in a contest where you’ll have a chance to win a new iPad, Google Nexus, or Kindle Fire!
Life insurance tends to get a bad reputation even though most people have a legitimate need for coverage. The main problem is that there are many different types of life insurance and almost all policies are sold by someone working on commission. This scenario is perfect for abuse when you have people pushing a product to make some money and ends up caring more about the commission than finding the right amount of coverage with the right type of policy. Because of this you’ll often hear stories about how someone got sucked into a massive whole life policy at a young age, or signed up for million dollar term life when they don’t even make $50,000 a year and don’t have any kids.
These stories may be fairly common, but it doesn’t mean life insurance is a bad product or that you should shy away from determining how much life insurance you need. If you understand the different types of coverage and calculate how much you really need you’ll be able to get the protection you desire without feeling ripped off for buying too much or getting into the wrong policy.
Do I Even Need Life Insurance?
Before going on to find out how much life insurance you need you must first determine if you even need it. If you ask someone who sells insurance for a living they will tell you everyone needs life insurance regardless of what their situation is in life. This just isn’t true. There are plenty of people and situations where life insurance simply doesn’t make sense. So, how do you know if you’re someone who needs life insurance or not? Here are a few general rules to follow:
You probably need life insurance if:
- You are married.
- You have children.
- You have a desire to leave a beneficiary something upon your death.
You probably don’t need life insurance if:
- You are single.
- You are older and your children are no longer dependent.
- You are married but only your spouse earns an income.
Now keep in mind that these are generalities and not black and white questions. There are situations where there may be a combination of factors going on that warrant coverage even if the general consensus says otherwise. To put it simply, ask yourself this: If I were to die, would that place a financial burden on someone else? If you answered yes to that question that’s a pretty good indication that you need some sort of life insurance.
The Different Types of Life Insurance
Once you’ve determined that you could use some life insurance you’ll then want to consider the different types of life insurance options. To keep things simple, life insurance is generally broken down into two forms: term and cash value. Term life is just what you’d suspect. It’s an insurance policy that is only effective for a specific term and when that term is up the coverage ends. Policies that have a cash value come in a few different forms, but their goal is the same. They provide a death benefit just like term life but they don’t expire after a certain number of years (as long as you stay current on premiums) and a portion of your policy premiums build up cash value over time.
To get a better understanding of the different types of policies let’s look at some of the details of each:
Term Life - This is the cheapest way to obtain life insurance. You select the length of coverage, typically 5, 10, 20, or 30 years, and make premium payments as long as the term is in effect. The premiums typically remain the same for the life of the term and when the term is up you stop making payments and the death benefit goes away. Term life is cheap because the policy only lasts a set number of years and doesn’t have any sort of cash value or investment option. Term policies are best for those who need coverage for just part of their life such as while they are married and in their prime earning years or while there’s a dependent child in the house.
Whole Life - Unlike term life insurance whole life is meant to provide a death benefit for someone’s entire life as long as the premiums are paid. Because these policies are effective in most cases until someone dies the premiums are much higher since the insurance company will almost certainly have to pay out a death benefit at some point. Whole life also has a cash component that will take part of each premium payment and set it aside in a separate account earning a set interest rate. Because of the significantly higher premiums and low rates of return on the cash portion whole life is almost never recommended for young people simply looking to protect their family. Like term life, generally the premiums remain the same for the life of the contract.
Universal Life – Similar to whole life in terms of having a cash component and still unlike term life, universal policies provide a little more flexibility over whole life. With universal life you can usually increase or decrease the death benefit at some point in the future and you may have a few different investment options for the cash value component of the policy.
Variable Universal Life – Here’s where things get a bit complicated. Similar to the other cash value policies you pay a higher premium than term life and some of that goes into an separate investment account. But instead of generally earning a regular interest rate you have the ability to invest that money into a all sorts of things such as mutual funds, putting your money at risk. These investments also increase the total fees paid which hurt your returns but help pad the insurance salesman’s wallet. These are the policies that have really given insurance a bad name in recent years and since very few people have a situation in where this type of policy can help you should probably think twice if someone mentions a VUL to you.
Calculating How Much Life Insurance You Need
So, you’ve determined that you do need life insurance and have identified the type of policy that’s right for you, but how do you come up with the magic number for how much coverage to have? It’s not as hard as it sounds so let’s walk through the process.
First, take stock of any life insurance policies you already have. Maybe your parents took out a small whole life policy on you when you were just a child or maybe you already have some coverage through your employer. While you’ll want to take any existing policies into account, don’t hold them with as much weight because like with your employer’s insurance it may disappear if you change jobs, or the little policy your parents took out on you might be too expensive to keep paying premiums on for the provided death benefit so you may opt to cancel or cash it out.
Next, look at your other assets that would be given to your beneficiaries upon your death. If you have a 401(k), IRAs, property, or other assets that have your spouse or kids listed as beneficiaries they will receive the bulk of those proceeds upon your death just like they would from an insurance policy so these funds may offset some of the coverage you think you need and can help you keep premiums down.
Using Income Rules of Thumb
Now it’s time to look at how long you need coverage. We’re going to assume you’re looking at term life which is the most common so you probably want to have coverage while you have dependent children, so you’re usually looking at a 20-30 year term. For sake of calculations we’ll go with 20 years. If you need coverage for 20 years you’ll want to start with the worst-case scenario if you were to die in that first year. How much money would your spouse and/or dependents be missing out on if that were to happen? If you make $50,000/year the easiest way to figure that would be to take $50,000 x 20 years, or $1,000,000. That means if you were to die within the first year of the policy your beneficiaries would receive enough money to directly replace your lost income for the next 20 years.
That’s a good rule of thumb, but it’s not always as simple as that. For example, your income probably wouldn’t remain static for the next 20 years and you’d probably receive pay increases over time. On top of that you want to factor in inflation. Remember, $50,000 in year 1 is going to be worth a lot more than $50,000 in year 20. So, maybe you take your replacement income and come up with an average inflated number to use for your calculation. If you make $50,000 today and expect your pay to increase with inflation you might expect your income to be upwards of $90,000 by then. Without getting too complicated you could then use these two numbers and split the difference for an average income over that time and maybe use $75,000. So with $75,000 x 20 you get $1.5 million.
Remember what we talked about above with looking at existing policies and assets? Well, if you have say a $50,000 policy through your employer and $200,000 tucked away in retirement accounts and other assets you could reduce your life insurance death benefit accordingly and save on premiums. So instead of $1.5 million you may only want to get $1.25 million in coverage. There is no right or wrong way to figure this in, but keep that in mind so you can balance your true death benefit needs and keep premiums as low as possible.
Using a Bare Bones Approach
The income rule of thumb above is great for maximizing your death benefit to ensure your beneficiaries don’t miss a beat, but covering two people to match their income for the length of the term may put the insurance premiums out of reach for many. That’s ok. What a lot of people do instead is take a look at their financial situation and determine what the bare minimum of coverage should be so that if something were to happen your spouse or children aren’t faced with a financial hardship. For most families this means keeping up with the mortgage and car payments, paying off other debts, and putting some food on the table.
So, that means you can determine how much coverage you need so that you can alleviate those concerns for your loved ones. Assuming the worst-case again where you die in the first year of the policy you should add up all of your current debts. Say you owe $150,000 on your current mortgage, owe $15,000 on a few cars, and have $5,000 in credit card debt. If you were to die your spouse and children would be left to live on just one income and still need to keep up with all of the above debt payments. But you can add up those debs to get a bare bones number: $150,000 + $15,000 + $5,000 = $170,000. To be safe, you may want to tack on another $10,000 that would be used to cover funeral expenses. So, here we’re at a $180,000 death benefit.
To understand how this may be all you need, consider what happens if you were to die in the first year. That $180,000 would be enough to pay off the house, the cars, wipe out the credit card debt, and pay your final expenses. With all of those things eliminated your spouse doesn’t have a mortgage, car payments, credit card bills, or any of that to worry about. As long as they are working there’s a good chance their single income will be more than enough to live off of.
Making Sure You Can Afford Life Insurance
You’ve seen the two extremes in the examples above. You can go all out and give your beneficiaries complete replacement income or you can get just enough coverage to eliminate your existing debt so they don’t have to worry about trying to make the payments when you’re gone. It goes to show you that there’s no right or wrong answer when it comes to determining how much life insurance you need. Your priorities, financial situation, and use of the death benefit will determine how much you should have. For some it might be a lot, but others may only need a little. So, don’t get caught up on numbers people throw out there as must-haves when it comes to insurance. It’s up to you to decide that.
But whatever you decide it’s important to make sure it fits within your budget. If your premiums cut into how much you’re able to put into an emergency fund, save for retirement, or pay down your debt, you’re buying too much insurance. Those items should take priority and insurance should be something that you can comfortably add on to your monthly expenses without negatively impacting the other areas of your budget.
To give you an idea, term insurance is much more affordable than you may think. For example, my wife and were shopping for policies and for non-smoking 30 year olds we were looking at $500,000 20-year term life policies around $240/year or $20/month. 20 bucks a month, that’s it! When you look at how much you might spend on things like cell phones, internet access, your daily Starbucks and so on, it really puts things into perspective. It really wouldn’t cost much to make sure our family is taken care of if something happened one of us.
But insurance premiums vary greatly, so the only way to know how much it will cost is to get a quote. If you’re curious as to how much life insurance will cost you, get a free quote today.
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