How much life insurance should you have?
Having the right amount of coverage is key to a solid financial plan for some people. Why did I say just for some people? Let’s take a look at your insurance needs and how much you may need.
If you die prematurely, life insurance is in place to take care of your financial responsibilities. Your beneficiaries get a lump-sum payment that they can use any way they choose. Often survivors pay off the mortgage and other debts, then invest the remaining money to create a steady income.
Ask yourself? Do you need any life insurance at all?
Many people really don’t need any life insurance. If you aren’t financially responsible for anyone else, you may not need life insurance. Or, if your children are grown and on their own that’s another reason to reconsider your need for life insurance.
But, what if you are financially responsible for your family?
Life insurance is an important piece of the financial planning puzzle if you still have a young family or are financially responsible for people in your life.
When trying to figure out how much life insurance people take their income, multiply it by a random number, and use that to determine how much coverage they need. You’ll get a much more accurate accounting of how much insurance you need if you think about your cost of living (now and in the future) rather than focusing on your income.
What are your costs?
The simplest way to figure out how much coverage you need is to work backwards. First, figure out what it costs your family to live each month, including monthly savings. Let’s say you spend $4,000 a month on living expenses and taxes and put away another $1,000 a month for retirement and other savings needs. That’s $5,000 a month or $60,000 a year.
Let’s say your spouse brings home $20,000 a year and would continue working if you die. That means your family is going to need to find another $40,000 to pay the rest of their expenses.
Now let’s do some math. Take that $40,000 (which is the annual shortfall) and divide it by 4% to determine how much capital would be required to earn $40,000. Why divide by 4%? Because we are going to assume that your survivors could earn 4% on the money over the long run after you die.
It’s true that the bank isn’t paying 4% right now, but your family may invest your insurance proceeds in something other than the bank?
If you do that math, you’ll come up with $1,000,000. That’s the amount of money your family will need to invest in order to generate $40,000 a year if they could invest at a rate of 4%. Is that the amount of insurance you need to buy? No, because it’s not enough!
Add to this $1,000,000 any debts you want to pay off if you die. For example, let’s say you have a mortgage of $200,000 and other debts of $25,000. If we add these three numbers together we get $1,225,000. If we keep things very simple that’s the amount of life insurance you need. If you have a solid financial plan in place, you should probably buy $1,225,000 term insurance that would last until you retire. In other words, if you are 45 today and plan on retiring at 65, a 20 year term policy might be the ticket.
What about other expenses like college education, home repairs, replacing old automobiles and travel? In a perfect world, your spending and saving number already includes these expenses. But if you have some large outlays in the future that you haven’t been saving for, it’s best to add those costs into this exercise.
What about the impact of inflation?
The younger you are the more you have to be concerned about inflation. Even modest increases add up. That means that your survivors are going to have to come up with more and more money just to maintain their current standard of living as the years go by. The good news is that doesn’t have to be a problem.
If your family invests prudently, they should be able to withdraw 4% of the proceeds each year and bump it up annually to cover the costs of inflation.
In order to determine how much life insurance you need, start by figuring out how much you contribute annually towards your family’s living costs. Take that number and divide by 4%. Then add other big ticket expenses that your family will need to pay for down the road and subtract out any savings you have that isn’t targeted for other purposes.
This calculation isn’t exact. But it’s an exercise nonetheless. And, it’s a lot better than guessing or ignoring this very important topic.
Give us a call to determine if you have the right type of life insurance and if it will cover your family’s cost of living