How Much Life Insurance Do I Need?

InsuranceKey Takeaways: 

  • The purpose of most life insurance policies is to ensure that your loved ones will be financially secure upon your death. Keep the big picture in mind.
  • Instead of using rules of thumb, consider your specific situation and determine an amount that will allow your loved ones to maintain their standard of living.
  • In addition to income replacement, consider other large future expenses you’d like to insure against if you die prematurely. 

Normally when people pay good money for something, they expect to see the value immediately. That’s why insurance is a hard concept for many people to wrap their heads around. Why? It’s an intangible and the best thing that could happen is that you never actually have to use it.

This article by financial planning expert Michael Kitces is one of the best summaries I’ve read about the concept of insurance. According to Kitces, “decisions to purchase insurance and/or seek out guarantees should always be viewed from the perspective of seeking to trade a small known loss to avoid a big unknown loss instead.”

In other words, you should only insure against losses that could be potentially catastrophic.  That’s why most warranties and other types of “insurance” on easily replaceable items are a waste of your money.

There are other types of insurance policies that are also critical for most people to have–disability, homeowner’s, umbrella, etc.—depending on your situation.  But when it comes to insuring your family against a potentially catastrophic loss, you need life insurance.  Below I’ll summarize how to potentially determine the amount of life insurance you need at your current age and stage of life. In future posts I will cover different types of life insurance and how long to keep your policy.

For now, just understand that good life insurance policies are designed to ensure that your loved ones will be financially secure upon your death.  Ask yourself, “If I were to pass away today, what funds would my loved ones need to maintain their standard of living?”  This approach is often better than conventional rules of thumb such as 8-to-10 times your current salary.

A little ditty about Jack and Diane

Let’s use a simple example of Jack and Diane, a 40 year-old married couple with a 15 year-old daughter (Brenda) and a 12 year-old son (Eddie). Jack is an accountant who makes $100,000 per year, and Diane is a stay-at-home mom. The family has an outstanding mortgage balance of $200,000.  Jack is considering purchasing life insurance given his family is completely dependent upon his earnings. How much life insurance should Jack buy today?  Below is one way to estimate that number. Keep in mind that there is no single right way to make this calculation, but focusing on your most likely insurable needs is a great place to start:

  • Burial – Jack has made it known that he wants no more than $10,000 spent on his funeral proceedings.
    • Burial insurance amount = $10,000 
  • Income Replacement – Since Jack is the sole earner, he needs to discuss with Diane if she would plan on returning to work in the event of his death.  In this example, we’ll assume Diane does not want to work, so Jack plans on insuring her expense needs for the rest of her life.  They recently did a detailed budget, so Jack estimates she’ll need about $60,000/year for expenses.  Based on life expectancy for a 40 year old woman, Jack decides to insure an amount for 45 years, or until Diane is 85.  We’ll assume an inflation rate of 3 percent annually, and since Diane will invest the death benefit, we’ll use a conservative annual growth rate of 4 percent on the insurance proceeds. The present value of this calculation is $2,200,204, which represents the amount of insurance needed to cover this risk. (Edit: We previously understated this amount. Thanks to Bill Bradley for his double check of this calculation).
    • Income replacement Insurance  amount= $2,200,204 
  • College Expenses – Jack and Diane plan on sending both their children to 4-year universities and will pay for their undergraduate degrees. Although the couple has managed to save $50,000 in 529 plans for both children (great choice by the way), they’ll need an additional $50,000 a year for each child to attend school. Since college expenses are in the fairly near future for Jack and Diane, they should insure the entire remaining $300,000 needed ($50,000 per year x 3 years x 2 children).
    • College insurance amount = $300,000
  • Mortgage – The only significant outstanding debt that Jack and Diane have is their mortgage. So, Jack would like to make sure Diane has enough money to pay off the home mortgage completely in the event of his death.  Any extra money that Diane collects can be used towards her retirement.
    • Mortgage payoff insurance amount = $200,000 
  • Wedding – Jack and Diane would like to give each of their children $25,000 toward their weddings.  There’s no way to predict exactly when those events will occur, so as a starting point, they anticipate each of their children getting married when they reach age 25.  Given a 4 percent rate of return, they would need to insure $16,889 today for Brenda and $15,014 for Eddie to make these $25,000 gifts when the children reach age 25.  Any extra money would go toward a wedding gift.
    • Wedding insurance amounts = $31,903

In total, Jack needs to purchase a life insurance policy of approximately $2.7 million in face value (see table below).  These funds should sufficiently cover Diane’s and the children’s expenses in the event of his death.

Burial insurance amount                      $10,000
Income replacement insurance       $2,200,204
College insurance amount                 $300,000
Mortgage payoff insurance                $200,000
Wedding insurance                              $31,903
TOTAL                                           $2,742,107

Conclusion

As stated above, this is a simplistic example of how you can determine your insurable need since it doesn’t take into account current savings, retirement assets, lifestyle choices, etc.  But the detailed process of determining what your insurable need truly is will be the same.  Since we are fee-only financial planners that don’t sell life insurance, we can provide an unbiased opinion about your life insurance needs.  Please don’t hesitate to reach out if you have questions or would like our help.

About Patrick Runyen

As a Wealth Manager at Independence Advisors, Patrick Runyen, CPA/PFS, CFP® works closely with clients to implement wealth management solutions. He leverages his technical financial planning and consulting experience to assist clients with investment counseling, retirement planning, estate planning, wealth enhancement, asset protection, tax planning, and other personally significant financial decisions. CLICK HERE TO ASK PAT.

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