Financial Resource Center


Life Insurance: How Much Is Enough?

by Dianne Molvig / October 15th, 2012

Who isn't looking for ways to scrimp and save these days? When you're faced with meeting expenses in the here and now, it's tempting to put off paying for seemingly remote needs, such as life insurance. "People think, 'I'm healthy. I'm careful. Nothing is going to happen to me,' " says Mark Zaifman, a Petaluma, Calif., financial planner. "We have all these rationalizations and talk ourselves into believing we don't need life insurance." Indeed, four out of 10 U.S. adults had no life insurance as of 2011, according to LIMRA, an insurance marketing research firm headquartered in Windsor, Conn. For some adults, of course, life insurance isn't a necessity. "But if you have anybody dependent on your income, you absolutely can't afford to go without it," says Kathy Stearns, a financial planner in Boise, Idaho. "It's a critical piece of any financial plan." Not having any life insurance is one peril. Another, perhaps even more common, is owning a policy but having insufficient coverage, says Lea Ann Knight, a financial planner in Bedford, Mass. People who have a group policy at work, for instance, often figure they've taken care of life insurance. "They don't realize that's not enough," Knight says. "If you die and all your spouse gets is one year of your salary, that's not going to cover much."

Figuring your coverage

So what is the right amount of coverage? Sometimes you'll hear rules of thumb, such as buying coverage equal to eight to 10 times your annual salary. But financial experts agree such formulas are of little use. Two people with the same salary may have vastly different life insurance requirements.
We rationalize and talk ourselves into believing we don't need life insurance.
To get a better idea of what you should buy, consider your survivors' short- and long-term financial needs, including:
  • Final expenses—Enter into your calculation the amount needed to pay for your burial or cremation expenses.
  • Major debts—Add in debts you'll leave behind, such as a home mortgage, college loans, car loans, and significant credit card balances. Include any outstanding debts that would be a heavy burden on your survivors.
  • Your children's college expenses—Decide how much of this you want to cover with life insurance. A portion? All of it? "This is a less critical piece," Knight says, "because there are lots of other ways for your survivors to pay for college." If you decide you want to use life insurance to pay for some or all education expenses, figure what college will cost by the time your kids get there. College tuition tends to increase about 8% a year, on average, according to FinAid.
  • Income replacement—Once you've covered all those categories, calculate what your survivors will need to cover the rest of their ongoing expenses. A major one to include is health insurance. If you're the one who has coverage through your job, your family will have to buy other coverage after you're gone. To calculate income replacement, Zaifman likes to use a 50%-of-salary figure. "You don't need 100%," he explains, "because you've already covered your mortgage, other debts, and so on." Say you earn $80,000 a year and would work for another 25 years. Using this guideline, your income replacement figure would be $40,000 times 25, or $1 million.
    Coverage for a nonincome-earning spouse may be critical to your family's financial future.
    Stearns offers a different path for calculating income replacement. Say your family needs $40,000 a year to cover living expenses—again, assuming you've already covered the mortgage, other debts, and so on. Stearns divides $40,000 by 4%, or .04, which yields a total income replacement figure of $1 million. "The 4% number is based on a lot of analyses of how much you could take out per year to make a portfolio last for 30 years," she explains. "It's based on historical data." Thus, according to this calculation method, $1 million should last your survivors for 30 years if they were to withdraw 4%, or $40,000, each year to live on. Whatever method you use for the calculation, remember, "it's not precise," Stearns says. "But it gives you a ballpark figure." After you add up all the categories, subtract any sizable assets. Perhaps, for instance, you've already built a hefty retirement account your survivors would inherit. That would diminish how much life insurance you should buy. A financial planner can help you determine the right amount of coverage to buy. Seek advice, though, from a fee-only financial planner, one who provides advice for a fee, but does not sell financial products—such as life insurance.

    It's personal

    Your personal goals also enter into your insurance-buying decision. "Some people may want enough coverage to help their spouse get back on his or her feet after a couple of years," Zaifman says. "Some want the surviving spouse to never have to work. Those are personal decisions that require thought, careful analysis, and deep soul-searching."
    Two people with the same salary may have vastly different life-insurance requirements.
    You may be surprised at the number once you figure how much coverage you actually need. Still, life insurance is a good buy. "If you're young and healthy," Stearns says, "you can buy a lot of term life insurance for a few hundred dollars a year." But if the premium is still out of reach, buy what you can afford now. "Take a baby step to get started," Zaifman advises. "Even a $100,000 term policy is better than nothing." You can purchase more coverage when you're able. Remember, though, the older you get, the higher the premium you'll pay. That's why it's better to scour your budget now, Zaifman recommends, to see how you could afford the coverage you truly need. Trimming $10 here and $20 there may add up to $100 a month you could apply to buying a policy. Coverage for the breadwinner is paramount. But coverage for a nonincome-earning spouse also may be critical to your family's financial future. "That stay-at-home spouse is providing child care that will have to be paid for if he or she dies," Knight explains.

    Needs will change

    Once you decide how much life insurance to buy, you're not finished. You'll need to rethink your coverage at certain key life transitions: marriage, divorce, birth of a child, buying a bigger house and taking on a bigger mortgage, children setting out on their own, paying off your mortgage, and so on. But the moment to examine your life insurance needs for the first time is now. Sure, thinking about your demise is unnerving, and buying insurance feels like a hassle. "But you have to recognize," Knight advises, "that buying life insurance is the first thing you should do, before you start investing or saving for retirement. Those goals will never be realized if something happens to you and you don't have enough coverage."
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