I have a love-hate relationship with life insurance. On the one hand, I love it. It helped me get through college and have a life. It also helps me sleep at night knowing that my family would be taken care should something terrible happen to me (God forbid).
I also hate it because many agents misrepresent it. They sell you the wrong kind of insurance and the wrong amounts. Their primary objective is often to maximize their own financial security rather than yours. Don’t let their character flaws influence your decisions about this important topic.
Do you need life insurance?
Life insurance has only one purpose: to complete your financial responsibilities if you die. That’s it. If you have no dependents you don’t currently need life insurance. Don’t fall for a common trap: life insurance is not an investment.
If you do have dependents you should buy term rather than whole life. I’m going to assume you are familiar with term and whole life insurance. It is a good idea to familiarize yourself with your options.
How much life insurance should you buy?
Remember, life insurance is meant to make up for your lost income. So we need to figure out how long your dependents will depend on your income.
One rule of thumb is to multiply your income by 17 and buy that amount of insurance. So if you bring home $48,000 a year you need $816,000 in term insurance. This is a rough estimate but let’s see if the rule of thumb works.
Without getting bogged down in lots of detail, let’s make some assumptions and break this down.
- You and your spouse are 45 years old.
- You each bring home $4000 a month for a total of $8000.
- You have one child age 7.
- You will retire in 20 years.
- The $8000 in monthly income allows you to save for your child’s education and your retirement.
- If one of you dies, your expenses will increase by $1000 monthly to pay for extra child care for 5 years.
- Inflation will be 3% over the next 20 years.
- Investment return will be 5% over the next 20 years.
- You already have $150,000 in savings.
So, in this example, you need to replace $5000 in monthly income for the next 5 years and then $4000 for the next 15 years. Tell you what, we’re just going to replace $5000 for the next 20 years and give the surviving spouse a little bonus for putting up with you as long as they did.
How much term life insurance do you need?
Go to this calculator and input your desired income ($60,000), number of years (20) and rate of return (2%).
We used $60,000 because that represents $5000 in monthly income for 12 months. We also used 2% for the rate of return which is 5% return less 3% inflation. Mathematically, that isn’t 100% the way to do it but it really is close enough for what we need.
Input those numbers and your result is $981,085. Now, subtract the $150,000 that you already have and you need to buy $831,085 in term insurance.
How long do you need it for? 20 years of course. By then, according to your plan, you’ll have enough to retire on.
In this particular example, the result is pretty close to the rule of thumb calculation. You should buy $850,000 in term life insurance. The best way to buy this coverage is to shop on the internet for free rate quotes.
If we want to complicate this issue, we’ll notice that the amount needed decreases each year. This exercise calculates the amount you need right now. You could easily re-run this exercise each year to see if you still need the same amounts.
Just remember two things:
- Only buy term life insurance for income replacement and family protection.
- Think of life insurance in terms of income replacement. How much income will you need and for how long?
Once you determine that, it’s easy to figure out how much you need to buy.
This is a guest post by Neal Frankle. Neal found himself in a financially fragile situation at the age of 17. Both his parents passed away while he was still in high school, leaving behind a small insurance settlement. Neal sought out a financial advisor to help him invest his nest egg so that it would help put him through college. Instead, the advisor charted a self-serving course and was on the verge of burning through the money when Neal realized what was happened and fired him just in time to avoid losing everything.
The experience had a deep impact on Neal and formed in him a lifelong desire to help people learn to make smart financial decisions. Today, with more than twenty-five years of experience in the financial services industry, Neal is an author and avid blogger.