What do I need to consider to determine the amount of life insurance that I need?
Answers | 5
There are three areas of concern:
Immediate debts that must be paid at the death of the insured,
Expenses related to the death of the insured,
The on-going expenses that must be met on a monthly basis.
Subtract from the monthly need the amount of income available from other sources.
Once you have determined the monthly shortfall, multiply the result by $400. This is the amount in savings that you would need, earning 3%, to provide that amount
For a more detailed understanding of life insurance and its place in one's financial planning, you can request a copy of my report by e-mailing me.
Some people use insurance to cover their assets like house or business or start a business. Some people use insurance to have extra to cover the expenses when they retired, specially Long Term Care. Some people use insurance to give to a foundations, pets or loved ones when they gone. You see! there lot of things that you can do with insurance but you don't want to put all your eggs in one basket. You need to talk to an expert so they can help you diversify your portfolio or distribute your money equally.
I’m not sure if I completely follow either answer previously provided and I’ve been licensed to sell life insurance for over 22 years. There was nothing incorrect about either answer, but neither seemed to directly answer your basic question.
I assume you are not using life insurance as a supplemental retirement income source. If you were the answer to your question is “the lowest amount that will allow your policy to qualify as life insurance” thereby preserving the tax-free access to your cash values.
However, since you are (most likely) looking to provide a death benefit to someone else and this is not for cash accumulation for yourself, let’s first start with the reason you are looking to purchase the life insurance? Is it to “create an estate” (i.e. deliver a lot of money to someone at your death) or is the policy being purchased to “replace your income” (i.e. to continue to provide for someone if you were to die)? These two reasons sound a little alike but the former is more of a “generous gift” while the latter is “needs based” and meant to replace a lost source of income.
If the reason is the former, then you determine how much life insurance you need by starting with how much you can afford to spend annually on the insurance. From there, the amount you can purchase will depend upon the type of insurance selected and how the policy is designed. There are way too many variables to provide further details in this answer and besides I’m guessing that your question is about income replacement or rather a need to provide for your loved ones in the event of your death. If I am correct and this is the case, then you can generally determine what amount is needed in one of two ways.
The first method is fairly simple… if you are looking to provide $100,000 of income (ignoring income taxes) then the general rule of thumb is to multiply the $100,000 by 20 to arrive at $2,000,000 in face amount (more commonly, but incorrectly, referred to as “death benefit.”) This is the 5% rule. 5% of $2,000,000 equals $100,000 – and this essentially allows the beneficiary to receive a $100,000 income for 20 years (if your beneficiary earns 0%) or a lifetime (if your beneficiary is able to earn 5% each year.) I’m not going to get into the details on how or even if this can be done safely in this day – but let’s just agree that how long the money lasts will depend on how it’s invested.
The second method is also fairly simple. You add up the liabilities that you want paid off at your death and purchase whatever amount of insurance is needed to pay that off.
There is a third method that involves some more complicated math like present interest value and time value of money calculations. This method attempts to specify a target amount based on cash flows, hypothetical growth rates and a whole host of other assumptions. In my many years, I have never used this method as most people seem to arrive at an amount that is comfortable using one of the two simple methods previously described. More importantly, over time these methods are never very accurate as circumstances are constantly changing making these calculations incorrect almost immediately after they are run.
For this discussion I have completely ignored the type of insurance you should purchase. The question here is term or cash-value life insurance. If the need to replace your income is temporary, buy term insurance. If your need is long term, buy a well-designed universal life insurance policy. Today, the best cash-value product is an equity indexed universal life insurance contract (or EIUL.) But please be aware, not all EIUL contracts are the same and there are many companies that sell EIUL that have terrible contracts. And in my opinion, many insurance agents do not understand this product well enough to sell it.
I know there are many insurance agents out there that have “drank the Kool-Aid” and will tell you to buy whole life, but when their motivation is dissected by someone like me, their recommendation is either based on their own compensation (and not what’s best for you) or a complete misunderstanding of EIUL.
Bottom line, from a beneficiary’s perspective - you can NEVER have too much life insurance. You should purchase what you are comfortable buying knowing the basics about the income that the amount you purchase will provide to your beneficiary balanced by how much you can afford to spend!
I hope this helps. I would be happy to answer any follow up questions you may have in order to help you arrive at an amount that is palatable to you.
Try this quick method for getting to the answer:
Determine how much you spent to get through life last month. Closer to $3k or closer to $5K? Let's say it was $4K to get Nancy and family through a month of living. Subtract $1K since when one of you passes, the monthly need will shrink a bit. That's $3K per month based on a "right now" number. That is also a $36K annual need. Multiply by 10 years, and your have a $360K bucket of money to draw from for that long - and it fits your monthly needs. I like this method because it does not look to future numbers that we cannot know at the present moment, but instead uses present numbers to cause you to think rationally about the death benefit and what it will do - and for how long.
See how using the current month's expenses (a reflection of your reality) lets you bottom line the annual and future needs? Want a 5 year bucket so that you pay less of coverage? Cut the $360 in half and buy that much. Hope that helps!
Two sources of income:
A) 5 to 7 times annual income, plus
B) Mortgage balance, plus
B1) Rental property mortgage balance (or balances), if applicable, plus
C) Outstanding debt (student loans, credit cards, auto loans, etc)
D) Future college costs for kids
One source of income:
Same as above but use 10 to 15 times annual income (instead of 5 to 7 times).
But make no mistake, these recommendations are "baseline" tests... Like the posts before me, this decision will probably be much more complex.
Good luck! And feel free to email me with any additional questions.