How Much Life Insurance Do You Need?
How much life insurance do you need? It seems like a simple question, but many online calculators don’t always give you the right answer.
Calculating your life insurance needs shouldn’t be so difficult, but it often feels that way. You’ve probably heard “rules of thumb” like “10 times your salary” or “20 times your salary.” While these guidelines will probably get you to buy more insurance than you have now, they’re not all that accurate at telling you what you actually need to insure your financial obligations. Here’s how to figure out what you really need:
Add Up All Of Your Debts
Life insurance is really about transferring the financial risk of your death away from you and onto an insurance company. Most people can’t afford to pay for their own funeral out of pocket. They also can’t pay off all of their debts immediately – if they could, they wouldn’t be in debt.
Child Day Care
Life insurance needs, therefore, are really limited to your current and future expected financial obligations. For example, your life insurance policy should be enough to pay off your credit card bills, your mortgage, and any outstanding medical bills.
However, it should also be enough to pay off future college expenses you expect to incur for your children’s education. Finally, it should cover any income you want to leave for your spouse.
Add Up All Of Your Current Income
Next, add up all of your current income. Take your average monthly income and multiply it by 12. If your spouse needs this to survive (i.e. if he or she stays at home and takes care of your children), then this is the amount of money you need to replace every year until your retirement age (assuming no future raises).
If your spouse only needs a percentage of your annual income, multiply by whatever percent she needs. Another way to approach this is to deduct any debts that you know she won’t have after you’re gone.
For example, your spouse may only need 75 percent of your income since she won’t be paying for insurance on your vehicle any longer, won’t have to pay for gasoline for it, and may end up selling it. She also won’t be paying for any personal hobbies of yours and the grocery bill may be smaller. Her monthly budget may be smaller since she won’t have to set aside money for your future retirement.
Also, don’t forget that life insurance proceeds are generally income tax-free, so your spouse’s insurance needs might not be as high as you think. In other words, you can base your life insurance needs on your net income, not your gross.
Add Up Future Retirement Income
Your expected future retirement income is something you can subtract from your life insurance needs. Since your spouse would be entitled to your retirement funds, you don’t have to worry about replacing them. Don’t forget to add up all of your 401(k) plan balances, IRAs, and pensions. Your Social Security benefits can also be claimed by your spouse, so include this income as well.
Adjust For Inflation
Adding up your total debts, and buying insurance to cover those debts, may only give you part of the total picture. If you are leaving an income to your spouse, you may want to adjust the death benefit for inflation. This gets tricky because of the math involved. However, the Life and Health Insurance Foundation for Education (LIFE), a nonprofit organization, makes it easy to adjust your death benefit needs for inflation: lifehappens.org/life-insurance-needs-calculator.
If you’re buying term life insurance, this will almost always be a necessity. If you’re buying participating whole life insurance, or universal life insurance with an increasing death benefit, your policy may counteract at least part of the effects of inflation.
