What you need to know
Ben Franklin said it best: “The only thing certain in life is death and taxes”. Not many folks like thinking about their own demise, but it’s our job as financial advisors to have these difficult conversations. So, once you accept your inevitable mortality the question is – what can you do to make sure your loved ones are taken care of in your absence? Typically the simplest answer is life insurance; it’s the low hanging fruit. Most people need it. Some do not.
Right now you might be wondering – “do I need life insurance?”. Better yet, if you know you do you’re asking “how much life insurance do I need?”. Check out this quick 6-step guide to figure out how much life insurance you need. And scroll down for a simple life insurance calculator to automatically have it answered for you!
How much life insurance do I need?
Step 1 - Your Family Situation
Generally, the default answer to “do I need life insurance” should be yes! In our opinion, it’s better to assume that you do need life insurance and be wrong than to assume you do not and be wrong. This is especially true if:
- You are the primary breadwinner in your household, and/or
- There are other human beings who rely on you
However, this doesn’t mean that if you’re single or don’t have kids you don’t need life insurance.
Step 2 - Debt
Rule of thumb #2: if you are in debt, you probably need life insurance. This is especially true if someone else is on the loan, such as a spouse, parent, or co-signer. Here are a few examples:
- Car loans
- Boat loans
- Credit card debt
- Private, non-government student loans (federal student loans are discharged at death)
Most debts are not erased just because you’re dead; your estate is left to settle any money you still owe. Without life insurance, assets such as bank accounts, retirement accounts, or other property will have to be liquidated to pay off your outstanding debts. More money going to creditors means less money left for your family and loved ones. And it’s not just spouses that can be left on the hook: creditors can go after co-signors as well. If a parent, relative, or friend co-signed on a loan for you such as a car loan or credit card, you’d be wise to get life insurance so they aren’t left holding the bag.
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Step 3 - Replace your income
Having your debts paid off is a great start to helping your loved ones, but you should also take into account the other expenses of daily life they’ll still have in your absence: groceries, utilities, cell phone bills, child care, insurance, taxes, new clothes for the kids, etc.
While your surviving spouse might spend less in certain areas (groceries, insurance, utilities) they will likely make up for in other bills that didn’t exist with both spouses in the picture, such as day care, child care, or after-school programs. Furthermore, you should also take into account whether your surviving spouse would want (or have the ability) to go back to work or switch jobs in the event of your death.
In other words, how much income the surviving spouse will need to make ends meet and for how long. Simply multiply your salary by the number of years you want to cover.
A young husband and wife are trying to figure out how much life insurance they need on the husband. He earns $100,000 per year and she is a stay-at-home mom. After talking it over, they decide that if something were to happen to the husband she would want to cover at least 5 years’ worth of his salary to help her make ends meet and get the kids through school. They would add $500,000 to how much life insurance the husband needs ($100,000 x 5).
Step 4 - Long-term needs
Don’t forget to include big picture, long-term financial objectives in your life insurance calculation.
For example, paying for the kids’ college or leaving a legacy for a favorite charity or your alma mater. A quick “back of the napkin” calculation should suffice. Take how much one year of college costs, multiply that by 4 years (if you want to pay for 100% of their school), and then multiply that by the number of kids you have.
Step 5 - Assets
How much life insurance you need also depends on what you have saved in the bank. Add up all your savings and/or anything that can be easily liquidated into cash. Absent life insurance, this is what will help your loved ones make ends meet in your absence.
- Bank account balances (checking, savings, CDs, money markets, etc.)
- Retirement account balances (401(k)s, IRAs, TSPs, etc.)
- Brokerage account balances
- College savings accounts (ex: 529s)
- Income that will continue even if you die (i.e. pension survivor benefits, rental properties, Social Security survivor benefits, etc.)
Step 6 - Subtract what you need from what you have
The last step to calculate how much life insurance you need is to subtract the totals from Steps 2-4 from Step 5.
In other words, take what you need to 1) pay off your debts, 2) cover ongoing living expenses, and 3) cover big ticket items, and subtract that from how much money you have saved. The difference is your starting point for how much life insurance you likely need. If the number is negative, you likely have enough savings and/or ongoing income to cover your family’s needs – meaning you probably don’t need life insurance.
If your needs from Steps 2-4 add up to $1,500,000 and you have $250,000 saved in brokerage and retirement accounts – then $1,250,000 is a good starting point for how much life insurance you need ($1,500,000 – $250,000).
On the other hand, if your total needs are $500,000 from Steps 2-4 but you have $1,000,000 in total assets, you likely don’t need life insurance. This could be because you have enough savings or your loved ones have enough income from other sources to meet their ongoing needs even without life insurance proceeds.
The Bottom Line
In general you should start with the default assumption of yes, you do need life insurance. Use our quick and easy life insurance calculator to find out in seconds if this holds true for you.
Think of it this way – what’s a better scenario, you dying and leaving life insurance money that your family doesn’t end up needing, or you dying without life insurance and your family is left with no means to financially support themselves? There is clearly way more downside risk in the second scenario.
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