Life Insurance: How Much Do You Need?

Few people own the right amount of life insurance, because there probably is truth in the adage that life insurance is sold, not bought. Most people avoid the topic until they have to address it. Those that do seek out life insurance often receive all their advice from one commissioned agents instead of from several more objective sources.

There are good insurance agents who carefully assess a person’s needs. Many others stick with a basic rule of thumb that a person should own life insurance equal to several times gross income. The exact rule of thumb used varies, and there is not much research to support a particular multiple. The variance was revealed in a study funded by Allstate to find how the level of life insurance ownership varied around the U.S. For example, people in Pittsburgh generally owned insurance equal to three times their incomes, while the highest level of ownership was in San Diego at 5.4 times income. Many insurers recommend coverage of up to 10 times income.
One’s level of income is not relevant to life insurance needs. Life insurance is to pay for expenses that will result from your premature death. The amount of insurance you should own depends on your age, the expenses that need to be paid, and how long those expenses need to be covered by insurance.

Consider two people with identical incomes. One person is older, essentially debt free, owns assets beyond his needs, and has children who are grown and established. His wife is the only dependent. The other person is younger, owns few assets, owes a mortgage, and has a couple of young kids. His spouse stays home with the kids.

The first person might not need any life insurance. There are no debts to pay, and his assets might be enough to maintain his widow’s standard of living. He might, however, need life insurance to pay estate taxes or choose it to leave an additional inheritance for his heirs.

The second person would leave behind significant debt and future obligations his income was expected to fund, such as family living expenses and college expenses for the children. In addition, his spouse might have to get a paying job. She might not be able to earn as much as he is, plus she likely would incur child care expenses and other costs to be able to take a job.
This example shows why income is not a good way to evaluate insurance needs. Instead, the multiple reasons for needing insurance should be considered separately. Then the total need can be determined.

The first expenses to consider are those that might be due in lump sums. The most obvious is estate taxes. There also could be debts, such as a mortgage, car payments, and credit card bills. Death-related expenses such as a funeral also are in this category. Education expenses for the children also could be considered lump sum expenses. You might want to have life insurance pay a lump sum to cover the expected education cost, and then have your spouse or a trustee manage the money until it is needed.

Some people also buy life insurance to make charitable gifts. This is a way of leveraging wealth, because premiums paid usually are a fraction of the death benefit of the policy. The charity ends up with more money than it would have received from annual gifts equal to the premiums.

A separate category of needs are recurring expenses that were expected to be paid from your income along with any expenses that might be incurred as a result of your absence.

The best way to determine this need is to list the annual household expenses. Don’t forget to add amounts for periodic expenses such as home repairs. Some people put contributions toward education expenses in this category. Subtract expenses that are likely to decline if you are gone, and add any expenses that might be incurred or increase as a result of your death, such as child care. Then, subtract any continuing source of income, such as Social Security Survivor’s Benefits, your spouse’s income, and employer payouts. The result is the total annual expenses that need to be covered.

After that, some people assume the life insurance benefits will be invested and only income and gains will be used to pay annual expenses indefinitely. That results in the highest life insurance coverage.

Another approach is to assume the principal will be spent over time along with income from the unspent benefits. In that case, you’ll need annuity tables or a calculator with an annuity function. If you want $40,000 to be paid annually for 20 years, you will need about $500,000 of life insurance. You might want to buy more insurance to compensate for inflation.

Some people want the insurance to cover the needs indefinitely. Others assume survivors will make adjustments after two to five years, greatly reducing the amount of life insurance needed.
The final step is to decide which needs to cover with term life and which with whole life or other permanent life insurance. Some needs are permanent while others expire over time. For example, your children’s education and your mortgage are not permanent obligations. If your youngest child is eight, a term life policy of 10 to 20 years is sufficient. The living expenses of survivors also might be temporary. You probably will assume that minor children leave home and become self-supporting at some point. Some people assume that a surviving spouse will seek employment and perhaps downsize the home.  Different needs might require different insurance policies.

Permanent insurance needs include estate taxes, charitable gifts, and the needs of a disadvantaged child.

A web site calculator using this approach is at www.life-line.org.