People often ask me ‘how much life insurance do you really need’? A $500,000 policy might sound like a lot of coverage, but how do you know if it’s enough in your situation?
Here are a few questions to help you calculate how much life insurance you need. In this example, we’re estimating the needs for a basic term life insurance policy.
1. Do you have other debt besides your mortgage?
Any other debt would require that you buy more life insurance to pay it off. Otherwise, it would come out of your estate and would leave less for your survivors.
2. How much do you spend each month?
Many people underestimate what they spend each month, but a quick look at your bank and credit card statements should give you the number you’re looking for.
It’s hard to protect your family if you don’t know how much you need every month. Don’t just guess. You might think that a $500,000 insurance policy is enough. It is a lot of money after all, but you might be surprised to find that it’s not enough once you review your statements and go through all the steps in this article.
What could your family do with that $500,000? Let’s say they invested it and could earn 5%. That amounts to $25,000 of yearly investment income. So, if you earn $25,000 in salary, a $500,000 term policy would be enough to replace your income. But if your family depends on more than $25,000 each year, you need more coverage.
3. What about other expenses?
Have you saved enough to fund other large expenses like future automobile purchases or the education of your children? If you don’t have funds set up for expected but nonrecurring outlays you might need more coverage.
4. How much income do your survivors need if you aren’t around?
This is the question you need to answer when it comes to determining how much life insurance you need. But to answer this question, you need to add up your answers to the other questions in this article.
Let’s say you spend a total of $6,000 each month to pay all your bills.
Let’s also assume that this $6,000 pays for everything including future college education, automobile purchases and retirement. Of the $6,000, you earn $4,000 and your husband earns $2,000.
You have a financial plan and figure that by age 65, your Social Security benefit together with the income from your investments will replace your earned income.
In this scenario, you would only need to replace your income until you reach 65. Since your husband earns $2,000 per month, you only need to replace the $4,000 that you earn.
Your $4,000 monthly income comes to $48,000 a year. You need enough term insurance so that if you pass away, you could invest the proceeds and earn $48,000 after tax. How much money would it take to earn $48,000 per year?
Assuming you could earn 5% on the money, you simply divide $48,000 by 5% and you have your answer. In this example, the number is $960,000. That’s how much savings you need to invest at 5% to earn $48,000.
You can’t use any other money you’ve saved to offset this $960,000. For example, if you have saved for retirement, you can’t use that because you will still need that money after you retire. The $960,000 is what your survivors need to get through until they reach the retirement stage at age 65.
Remember that if we used a more conservative rate of interest, like 4%, you would need even more insurance. $48,000 divided by 4% equals $1,200,000. That $500,000 policy would fall short of the mark by a long shot in this scenario!
5. What about inflation?
The cost of living keeps going up with every year. An increased cost of living means each dollar you have buys less. That means you need more money to replace your income. However, you might need less coverage as you age depending on your situation. Why?
Because in this example, the life insurance is only meant to replace your income until you reach age 65. By the time you reach that age, you will have enough to pay for sudden expenses out of your own pocket. By age 65 you will have passive income from pensions, Social Security and investment income. Your children should also be independent by then as well. As you get closer to 65, your risk is lower because you have fewer years left to carry the family.
How Much Life Insurance Do You Really Need
This is only a ballpark calculation but it’s a lot better than a wild guess. It’s pretty close to what you need, and it’s a calculation you can do yourself.
Remember, if inflation or interest rates were to change dramatically, you would need to recalculate your needs.
In this situation, I would recommend a term life insurance policy of at least $1 million. I would also recommend that you review your life insurance coverage periodically with your advisor to make sure you still have enough or possibly too much.
What happens if you don’t have enough life insurance?
If you don’t have enough insurance, you could be leaving your loved ones facing a financial burden should you pass away.
Your family might not have the funds to meet cost of living expenses and your pre-planned financial goals may no longer be attainable.
By having the right amount of life insurance, you will provide your family the stability to carry on without making any major changes in lifestyle or financial goals.
You can help us improve our blog by rating this article. You’re welcome to add your comments. Please share the article if you think others might find the information useful.