In a recent post, I provided some guidance as to who needs life insurance. If you determine that you need it, the next question is, “how much?”
You’ll hear about various guidelines for answering that question, usually based on multiples of your salary. Some say you should carry life insurance with a death benefit equal to 10 times your salary. But that’s is a broad-brush approach. It’s better to take time to consider how much you really need.
Running the numbers on life insurance
Either run a detailed analysis using a life insurance needs calculator, such as the one found on the web site of the non-profit Life and Health Insurance Foundation for Education, or follow this streamlined process recommended by Consumer Reports.
1. Estimate your current monthly living expenses: $_____
2. Estimate your family’s future monthly living expenses, assuming you are no longer living – I know, not a fun exercise, but it’s necessary if you’re going to make sure your family is provided for (Multiplying the amount from line one by .75 should give you a reasonable estimate): $_____
3. Estimate your surviving spouse’s future monthly income, including earned income, investment income, rental property income, and Social Security survivor’s benefits: $_____
4. Subtract line 3 from line 2 (This is your monthly shortfall that you’ll want to cover with insurance): $_____
5. Multiply the figure on line 4 by the number of months your survivors will need to cover the shortfall (Let’s say you came up with a $3,000 monthly shortfall in line 4 and you wanted to cover this need until a newborn reaches age eighteen. You would multiply $3,000 by 216 (12 months times 18 years) and come up with a needed death benefit of $648,000): $_____
I recommend one more step: add to the total you come up with in step 5 any other expenses you would want to cover in the event of your untimely death, such as paying off your mortgage or covering a child’s future college expenses.
Should life insurance benefits be used up or invested?
Whether you run a detailed analysis or use the simplified approach above, the death benefit you come up with assumes you will use up the life insurance proceeds as you spend them. In the example I just described, after 18 years of covering the $3,000 monthly shortfall with life insurance proceeds, the entire $648,000 would be gone. Actually, you would likely earn some interest in that time, but the assumption behind this type of needs assessment is that you will use the principal of the proceeds to pay expenses.
Another approach is to have enough life insurance so that if it were invested conservatively, the interest alone would cover the survivor’s needs; the principal could stay invested.
In order to generate $3,000 each month on an ongoing basis through interest income, assuming you could earn a 5 percent return on your investment of the insurance proceeds, you would need a policy with a death benefit of $720,000. A $720,000 policy, especially if you’re buying term insurance, may not cost all that much more than a $648,000 policy, and you would be further securing your survivors’ financial future.
I recommend that you estimate the total death benefit needed both ways — using the principal to cover the need versus conservatively investing it and using the investment returns to cover the need — and then compare the costs of buying the different amounts of insurance. You may decide it’s worth the added cost to buy enough life insurance to cover your survivor’s needs through investment returns.
Should both spouses have life insurance?
Be sure to estimate life insurance needs for both of you. Even if one spouse is not in the paid workforce, if you have minor children it makes sense to cover that spouse with life insurance. One approach is to cover that person for the cost of any services the surviving partner may need to pay for until the youngest child is on his or her own, such as childcare.
In our household, Jude takes care of our kids and manages our household full-time. We agreed that if something happened to her, we would want me to be more freed up from my work responsibilities to focus on raising our kids. We opted for enough insurance so that conservatively investing the death benefit would provide enough income for me to at least go down to a part-time work schedule.
Have you taken the time to estimate your life insurance needs? And have you purchased enough insurance?
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