Do you even need life insurance? If you have dependents to protect and you do not have enough savings, you will most likely need life insurance. But the question is how much should I have?
If you do not have dependents or you have enough savings to cover the current and future expenses for your dependents there really is no need for life insurance. Life insurance sales professional can be very aggressive with their sales tactics and sometime they mask their services as “financial planning” but all of their solutions lead to you buying an expensive whole life insurance policy.
Remember, life insurance is simply a transfer of risk. When you are younger, have a family, a mortgage, and are just starting to accumulate assets, the amount of life insurance coverage is usually at its greatest. But as your children grow up, they finish college, you pay your mortgage, you have no debt, and you have accumulated a good amount in retirement savings, your need to transfer that risk diminishes because you have essentially become self-insured. Just because you had a $1M dollar life insurance policy issued 10 years ago does not mean that is the amount you need now.
Which kind of insurance should you get?
It’s our opinion that for most individuals term insurance makes the most sense. Insurance agents are always very eager to sell whole life, variable life, and universal life policies. Why? They pay big commissions!! When you compare a $1M 30 year term policy and a $1M Whole Life policy side by side, often times the annual premium for whole life insurance is 10 times that amount of the term insurance policy. Insurance agents will tout that the whole life policy has cash value, you can take loans, and that it’s a tax deferred savings vehicle. But often time when you compare that to: “If I just bought the cheaper term insurance and did something else with the money I would have spent on the more expensive whole life policy such as additional pre-tax retirement savings, college savings for the kids, paying down the mortgage, or setting up an investment management account, at the end of the day I’m in a much better spot financially.”
How much life insurance do you need?
The most common rule of thumb that I hear is “10 times my annual salary”. Please throw that out the window. The amount of insurance you need varies greatly from individual to individual. The calculation to reach the answer is fairly straight forward. Below is the approach we take with our clients:
- How much debt do you have? This includes mortgages, car loans, personal loans, credit cards, etc. Your total debt amount is your starting point.
- What are your annual expenses? Just create a quick list of your monthly expenses, they do not have to be exact, and our recommendation is to estimate on the high side just to be safe. Then multiply your monthly expense by 12 months to reach your “annual after tax expenses”.
- How much monthly income do you have to replace? If you are married, we have to look at the income of each spouse. If your monthly expenses are $50,000 per year and the husband earns $30,000 and the wife earns $80,000, we are going to need more insurance on the wife because we have to replace $80,000 per year in income if she were to pass away unexpectedly. Married couples make the mistake of getting the same face value of insurance just because. Look at it from an income replacement standpoint. If you are a single parent or provider, you will just look at the amount of income that is needed to meet the anticipated monthly expenses for your dependents.
- Factor in long term savings goals and expenses. Examples of this are the college cost for your children and the annual retirement savings for the surviving spouse.
- Husband: Age 40: Annual Income $70,000
- Wife: Age 41: Annual Income $70,000
- Children: Age 13 & 10
- Total Outstanding Debt with Mortgage: $250,000
- Total Annual After Tax Expenses: $90,000
- Savings & Investment Accounts: $100,000
Remember there is not a single correct way to calculate your insurance need. This example is meant to help you through the thought process. Let’s look at an insurance policy for the husband. We first look at what the duration of the term insurance policy should be. Our top two questions are “when will the mortgage be paid off?” and “when will the kids be done with college?” These are the two most common large expenses that we are insuring against. In this example let’s assume they have 20 years left on their mortgage so at a minimum we will be looking at a 20 year term policy since the youngest child will done with their 4 year degree within the next 12 years. So a 20 year term covers both.
Here is how we would calculate the amount. Start with the total amount of debt: $250,000. That is our base amount. Then we need to look at college expense for the kids. Assume $20K per year for each child for a 4 year degree: $160,000. Next we look at how much annual income we need to replace on the husband’s life to meet their monthly expense. In this example it will be close to all of it but let’s reduce it to $60K per year. It is determined that they will need their current level of income until the mortgage is paid in full so $60,000 x 20 Years = $1,200,000. When you add all of these up they will need a 20 year term policy with a death benefit of $1,610,000. But we also have to take into account that they already have $100,000 in savings and their levels of debt should decrease with each year as time progresses. In this scenario we would most likely recommend a 20 Year Term Policy with a $1.5M death benefit on the husband’s life.
The calculation for his wife in this scenario would be similar since they have the same level of income.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.