If you are responsible for anyone else or want to help ease your family’s financial burdens when you are gone, you are probably thinking about buying life insurance. No doubt you are also asking yourself, “how much life insurance do I need?” Deciding on a coverage amount can feel like a daunting task. In fact, the process is not as tricky as it seems. First decide what kind of insurance you need and then answer some basic questions that can help you calculate your coverage needs. If your goal is to protect your family from estate taxes or the destruction of your company after your death, you should consider universal or whole life insurance. When the aim is primarily to make sure your family is protected against loss of income, a term insurance policy is the best option. Calculating the amount of insurance to buy is not difficult, but does require going through a few steps. While your coverage amount ultimately depends on your circumstances and plans, this process gives you an excellent idea of your life insurance needs.
1. How Much Non-Mortgage Debt Do You Have?
Decide how much debt you have other than your mortgage payment and whether you spend more than you earn. Ask yourself whether you add to your debt each month or whether you can pay it down every month. Calculate your total debt and ensure that your insurance policy will cover it.
2. How Much Do You Spend Each Month?
You can simply use your bank statements to figure out how much you spend each month. However, there are excellent calculators that simplify the task. A personal budget software package such as YNAB helps organize data and provides instant totals. It is important not to guess at your spending because you could leave your survivors without enough money for their needs. For example, a $500,000 policy might seem like a lot of money, but consider what your family might do with the cash. If they invest it and earn 5%, their annual income will be $25,000, which might not be enough.
3. How Much Do You Save Every Month?
Your long-term saving habits can help determine how much coverage you need. If you live within your means and save something every month, you might not need to replace all of your income, which means a smaller term life insurance policy.
4. What Are Your Long-Term Savings Goals?
Consider whether your savings plan includes enough for your immediate future needs and retirement. Will it be enough to pay for your kids’ education or a replacement car? If you believe your savings can cover expected, non-recurring expenses, you are on the right track. If there won’t be enough, you should increase your insurance coverage.
5. How Much Money Will Your Survivors Need?
The amount of money your survivors will need when you are gone is the most important part of your calculations. The answers to the previous questions give you the information you need to help determine this figure. For example, assume your budgeting software shows you need $6,000 per month to pay all expenses. Currently you earn $3,500 per month and your spouse earns $2,500. Also assume that amount will cover future expected costs. You can use those facts and the following method to determine your coverage needs:
- Your financial plan shows your Social Security benefits and investment income are enough to replace your income when you are 65. That is the age you can retire. You will need a way to replace your income until you turn 65.
- Your annual income is currently $42,000. If you buy term insurance, your coverage should be enough to allow survivors to invest the proceeds and earn $42,000 a year after taxes. You need to calculate that figure, which is actually simple.
- Assuming the money will earn 5%, divide $42,000 by 5% to get your answer. In this instance the figure is $840,000. That equals the amount of savings you need to invest at 5% to make $42,000.
- The $840,000 is the amount your survivors will require to live until they no longer need your income. You cannot use savings to offset this amount if those funds are reserved for retirement. However, other savings or insurance can offset the amount you need.
- You could add to your life insurance to adjust for inflation, but consider that once you reach 65, you may also need less coverage. By the time you retire, your children will be grown, so you will not be carrying an entire family and risk will be lower.
Buying life insurance to protect your family is part of good financial planning and you can determine how much coverage you need in just a few steps. You need to take a close look at your debt, spending, and savings. The resulting figures allow you to use a basic formula to calculate the right amount of coverage for your needs.