How Much Life Insurance Do You Need?

Posted by Madison on November 27, 2007

I received the following question from a reader:

I recently got married, and have been wondering how my spouse and I can determine the amount of life insurance we need in order to be financially secure, in the event that something would happen to one of us. -Summer

Great question Summer! Glad you are thinking ahead and preparing yourselves financially.

There’s a couple options:

  1. Use the rule of thumb. Often people discuss the “rule of thumb” for obtaining life insurance. Depending where you read it’s anywhere from 5-7 or 5-10 times your annual income. While it’s quick, it doesn’t account for your specific situation. You could end up overinsured or underinsured.
  2. Calculate a more precise number accounting for your income, expenses, debts. etc. You probably won’t need to replace all of the income because some expenses will go down (and others will go up) and it will be for a fixed time period. That’s the method we’ll focus on here.

Let’s walk through an example and the steps to calculate the amount of insurance needed.

Step 1. Look at Current Budget

Annual salary: Summer: $40,000; Ben: $40,000; Both age 30

Yearly expenses: $48,000 including ($11,880) house and ($7200) car payments

Yearly Savings: $16,000 (20%) Yearly Taxes: 16,000 (20%)

Mortgage: $160,000 (25 years left)

Net worth: $75,000

House payment: $990 per month, principal and interest

Car payment: $300 per month each

Step 2. Determine Impacts on Budget

Let’s consider what would happen if Ben died. Certain expenses would go away:

  • Ben’s car could be sold reducing gas, insurance, and one car payment.
  • There wouldn’t be a need for clothes, food, or entertainment for Ben.
  • His cell phone, health insurance and other regular expenses would be eliminated.
  • Income taxes would decrease.

Some expenses would stay the same:

  • House payment, assuming Summer stays in the same house.
  • Real estate taxes and homeowners insurance.
  • Static expenses like cable, telephone, etc.

Some expenses would increase:

  • Paying for tasks that Ben may have done around the house, like handiwork.

Here’s the numbers for Summer and Ben considering the impact on expenses.

Previous yearly expenses: $28920 (excluding house and car payments)

Less yearly expenses that would go away: $6000

Add additional yearly expenses: $4000

Net yearly expenses: $26920

Available for expenses: $24000 ($40,000 salary less $16,000 for savings and taxes)

Yearly Need: $2920

Step 3. Determine Timeframe for Needs

Summer plans to work 25 more years and retire early at age 55, with over a million dollars which she feels is a comfortable amount for her lifestyle. She used the calculators in Early Retirement: How much money will you need? to determine the time and amount needed.

Step 4. Calculate Amount Needed for Expenses and Timeframe

Summer needs $2920 for 25 years. Using the Savings distribution calculator at Dinkytown $70,000 should be more than enough to cover this for 25 years taking into account inflation.

Step 5. Add One Time Expenses

In addition, it’s good to account for some one time expenses that might be needed:

  • Funeral and burial expenses.
  • Paying off the house or car.

Summer also wants to pay off the house for $160,000 and her car for $10,000. They estimate $10,000 in burial expenses. The total amount of insurance that Ben will need to carry to protect Summer in case he dies is roughly: $250,000.

Step 6. Add a Contingency

Take this number and round up. Often you’ll be purchasing a policy now and not change it in the near term. The number we calculated would be the bare minimum to maintain the same standard of living. What if Summer and Ben buy a bigger house in 5 years? Have more expenses? Taking additional time off work to grieve is another cost to consider.

Summer and Ben know they plan to increase their lifestyle and Summer will want to take 6 months off work to work through the loss of Ben. They decide that $150,000 in a contingency fund will cover that. Therefore, $400,000 will be appropriate.

Obtaining Coverage

Once a target number is decided on, $400,000 in this example, determine the sources of money. Consider the following:

  • Beneficiaries on Ben’s retirement and bank accounts.
  • Social security $255 one time payment.
  • Coverage provided by an employer.

Any additional need usually must be met through an individual policy. Insweb is a good place to start in obtaining quotes. Because Summer has a fixed amount of time, she can purchase a term policy. After that she will no longer have a need for life insurance on Ben. This is often overlooked. Once a family reaches a level of financial independence, life insurance policies can usually be dropped.

Other Considerations

  • Consider children’s expenses, childcare and education if you plan to have a family now or in the future.
  • Reevaluate your need for life insurance whenever a life event happens, better yet, forsee it now and plan for it.
  • Long term disability is an even more important coverage to consider.

Action Plan

While it seems a bit daunting to put together all these numbers, it really is imperative that people are adequately insured. In this example Summer and Ben could have used the “rule of thumb” discussed previously, but it won’t work in every situation. Once you arrive at a number, get a quote and get coverage.

A good calculator is available at Smart Money once you have put the expenses together. I ran the numbers for this example and they came up with $388,149. The result was very close to the calculation above.

Thanks Summer, for asking the question and getting us moving in the right direction. I probably need to rerun our number and make sure we are carrying the appropriate amount.

Read part two when we determine how much life insurance to purchase on children.





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Comments to How Much Life Insurance Do You Need?

  1. Great post Madison, just came across it after reading Pinyos from today. Excellent resources for people that need a good starting point.

    Stumbling it;)

    CiaranFromChance


  2. Excellent – really valuable advice.

    Simba



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