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Inside this Article
How Much Life
Insurance Do I Need?
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In most cases,
if you have no dependents and have enough money to pay your final
expenses, you don’t need any life insurance.
If you want to create an inheritance or make a charitable
contribution, buy enough life insurance to achieve those
goals.
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If you have dependents, buy enough life insurance so that,
when combined with other sources of income, it will replace the
income you now generate for them plus
enough to offset any additional expenses they will incur to
replace services you provide (for a simple example if you do your
own taxes the survivors might have to hire a professional tax
prepare)
Also, your family might need extra
money to make some changes after you die. For example, they may want to
relocate, or your spouse may need to go back to school to be in a better
position to help support the family.
You should also plan to replace “hidden income” that would be lost
at death. Hidden income is income that you receive through your
employment but that isn’t part of your gross wages. It includes things
like your employer’s subsidy of your health insurance premium,
the matching contribution to your 401(k) plan, and many other
“perks,” large and small. This is an often-overlooked insurance
need: the cost of replacing just your health insurance and
retirement contributions could be the equivalent of $2,000 per month or
more.
Of course, you should also plan for expenses that arise at death. These
include the funeral costs, taxes and administrative costs associated
with “winding up” an estate and passing property to heirs. At a
minimum, plan for $15,000.
Other
Sources Of Income
Most families have some sources
of post-death income besides life insurance. The most common
source is Social Security survivors’ benefits.
Social Security survivors’ benefits can be substantial. For example,
for a 35-year-old person who was earning a $36,000 salary at death,
maximum Social Security survivors’ monthly income benefits for a
spouse and two children under age 18 could be about $2,400 per month,
and this amount would increase each year to match inflation. (It drops
slightly when the survivors are a spouse and one child under 18, and
stops completely when there are no children under 18. Also, the
surviving spouse’s benefit would be reduced if he or she earns income
over a certain limit.)
Many also have life insurance through an employer plan, and some
from another affiliation, such as through an association they belong to
or a credit card. If you have a vested pension benefit, it might have a
death component. Although these sources might provide a lot of income,
they rarely provide enough. And it probably isn’t wise to count on
death benefits that are connected with a particular job, since you might
die after switching to a different job, or while you are unemployed.
A
Multiple Of Salary?
Many pundits recommend buying life
insurance equal to a multiple of your salary. For example, one
financial advice columnist recommends buying insurance equal to 20 times
your salary before taxes. She chose 20 because, if the benefit is
invested in bonds that pay 5 percent interest, it would produce an
amount equal to your salary at death, so the survivors could live off
the interest and wouldn’t have to “invade” the principal.
However, this simplistic formula implicitly assumes no inflation and
assumes that one could assemble a bond portfolio that, after expenses,
would provide a 5 percent interest stream every year. But assuming
inflation is 3 percent per year, the purchasing power of a gross income
of $50,000 would drop to about $38,300 in the 10th year. To avoid this
income drop-off, the survivors would have to “invade” the principal
each year. And if they did, they would run out of money in the 16th
year.
The “multiple of salary” approach also ignores other sources of
income, such as those mentioned previously.
A
Simple Example
Suppose a surviving
spouse didn’t work and had two children, ages 4 and 1, in her care.
Suppose her deceased husband earned $36,000 at death and was covered by
Social Security but had no other death benefits or life insurance.
Assume the surviving spouse is 36.
Assume that the deceased spent $6,000 from income on his own living
expenses and the cost of working. Assume, for simplicity, that the
deceased performed services for the family (such as property
maintenance, income tax and other financial management, and occasional
child care) for which the survivors will need to pay $6,000 per year.
Assume that the survivors will have to buy health insurance to
replace the coverage the deceased had at work, and that this will cost
$12,000 per year.
Taken together, the survivors will need to replace the equivalent of
$48,000 of income, adjusted each year for an assumed 4 percent
inflation.
Thanks to Social Security, the survivors would need life insurance
to replace only about $1,700 per month of lost wage income (adjusted for
inflation) for 14 years until the older child reaches 18; Social
Security would provide the rest. The survivors would need life
insurance to replace about $2,100 per month (adjusted for inflation)
for three more years when the non-working surviving spouse has only one
child under 18 in her care.
The life insurance amount needed today to provide the $1,700 and
$2,100 monthly amounts is roughly $360,000. Adding $15,000 for funeral
and other final expenses brings the minimum life insurance needed
for the example to $375,000.
What’s
Left Out?
Some people like to
plan to use life insurance to pay off the home mortgage at the
primary income earner’s death, so that the survivors are less likely
to face the threat of losing their home.
If life insurance were
bought for this goal, the additional amount of insurance needed is the
amount of the unpaid balance on the mortgage. Some
people like to provide money to pay to send their children to college
out of their life insurance. We may assume that each child will
attend a public college for four years and will need $15,000 per year.
However, college costs have been rising faster than inflation for many
decades, and this trend is unlikely to slow down.
If life insurance were
bought for this goal, the additional amount of insurance needed would be
about $200,000.
In the example, no money is planned for the surviving
spouse’s retirement, except for what the spouse would be entitled to
receive from Social Security (about $1,200 per month). It could be
assumed that the surviving spouse will obtain a job and will either
participate in an employer’s retirement plan or save with an IRA, but
she could also become disabled or otherwise unable to work. If life
insurance were bought to provide the equivalent of $4000 per month
starting at age 60 until 65 and $3,000 per month from 65 on (because at
65 Medicare will make carrying private health insurance
unnecessary), the additional amount of insurance needed would be about
$465,000.
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