How to Determine the Amount of Life Insurance You Need

The following is a guest post from Marotta Asset Management.

You may have heard that "Life insurance is a gift of love." But if you bought a $100,000 whole-life policy because you wanted to build some cash value when you should have bought a million dollars of low-cost term insurance to meet the survival needs of your family, your well-intentioned effort was not an act of love.

Objective life insurance advice is hard to find. Prior to joining the National Association of Personal Financial Advisors (NAPFA), Bob Arms, CLU, ChFC, AIF®, coauthor of this week's column, sold life insurance for 26 years. He is currently licensed as a life insurance consultant, a fiduciary whose legal obligation is to represent the client first.

The first step toward representing your best interests entails an in-depth discussion of how much life insurance you might or might not need. The formula is Future Financial Needs minus Current Assets equals Your Current Risk. How much you want to provide for your loved ones should you predecease them (A) minus how much you have that could be used to provide for the survivors (B) equals your surplus or shortage (C).

To the extent that a gap exists between your financial needs and your current assets, life insurance is the most efficient product available to provide tax-free dollars exactly when you need them. As you go through the life changes of marriage, children, and career, you should recalculate your need and revisit the life insurance you own.

When members of a young family are making a decision about life insurance, six line items are significant.

1. Debts: The baggage of debt makes the journey toward financial success difficult. Avoid debt if possible, but if you have any, don't burden your family with it after you are gone. Being able to liquidate all credit card debt and car, home equity, and personal loans will give your surviving family the best chance at success in life.

2. Mortgage: Carrying a long-term fixed-rate mortgage keeps more money invested in the markets and qualifies you to enjoy a tax deduction on the interest. Leverage is a popular financial strategy of the rich. But if you would sleep better at night without a mortgage, sleep is more important. Either way, you need enough insurance or investments to pay off the mortgage.

3. Educational and child-care expenses: Depending on the age of your children, multiple expenses must be considered. If your children are preschoolers, the cost of child care may make it impractical for the surviving spouse to return to work. Consider the math. When the children are school age, will you want them to attend private school? Call the schools in your area and work the numbers. What percentage do you want to help with college? In-state tuition, room, board, books and transportation for college presently averages $6,185 annually. Private schools cost about $23,712 per year. Which do you want to fund?

4. Final expenses: Include a small amount for your funeral, approximately $10,000. The average funeral today costs $5,000 to $7,000, but expenses can exceed $10,000.

5. Family income: Estimating a young family's income needs is very challenging. To ease the mental strain, use seven times your adjusted gross income as a rule of thumb. A more accurate prediction requires either a financial calculator or a computer program.

6. Emergency fund: No one can forecast the exact amount a surviving family will actually need, but this category does absorb a potential miscalculation. Most gaps are filled by using 10% of the total of the other five line items: debts, mortgage, education, final expenses and family income.

Now that you have an estimate of how much your family needs, compare the total with your current assets. Include only the assets the surviving spouse can use for expenses. So do not include your house because your spouse needs someplace to live; your car because transportation is essential; or your retirement assets, which the surviving spouse will need during retirement. Nor should you count any inheritance. The old adage is true: Don't count your chickens before they hatch. This category is the total of your current life insurance and all investment assets.

The easiest math remains: Your Total Future Financial Needs minus Your Current Assets equals The Current Risk you may want to insure against. To determine how much life insurance the other spouse should carry, trade places as the first to die and rerun the numbers. Clearly, if the bottom line is positive, you've done something right and either you have enough life insurance or you are self-insured. Congratulations. If the bottom line is negative, thankfully you still have time to take action.

Financial planning is a lifelong process that covers multiple areas, including investments, insurance and taxation. Reviewing all of your financial affairs periodically with a trustworthy advisor who sits on your side of the table will ensure that you achieve your financial goals. 

Comments

[Denise Mancini-Blonda]

Great post. Unfortuantely, 1/2 of American's have life insurance and the majority of them a grossly underinsured with only 2xs income. The more we educate people on the importance of not only getting life insurance, but getting the right amount of life insurance, the better.

[sow]

To the author of the post -

Could you explain why you base the amount on "need"? Because really, if I based it on need, then that amount could be really small if I decreased my standard of living (i.e. live in an apartment eating only bread and water).

I have always based my amount of life insurance on "wants". If someone told me that I were to die tomorrow and I could get any amount of life insurance today, I wouldn't put a number on that amount. I would say, "As much as I can get."

And can you explain what self insurance means? Because I don't believe it exists. The assets you want to utilize and enjoy, because they are supposedly insured, cannot be utilized and enjoyed because they are acting as the insurance.

Your thoughts?

[FMF]

Sow --

1. Marotta Asset Management wrote this post. If you have specific questions for them, follow the link and ask them.

2. I'll be writing on what "self insurance" means in a month or so. Stay tuned.

3. Insurance costs money -- just like anything else. You want to balance your need (not wants) with the cost.

4. As I'm sure you know, insurance companies are very sophisticated and they know the odds that you'll actually need any sort of insurance. When you by insurance, you're actually losing money based on the statistics, but you're buying it "just in case" you are unlucky in the future. As such, you don't want "as much as you can get." (Unless you want to lose "as much money as you can.")

[sow]

3. Using the needs logic, If I base my home insurance on needs, then do I need to insure my home for 100% of its value? Probably not, because my needs could probably be met with 50% of its value. But homeowners don't do that. They insure for the total value of the home. How come some don't use this same logic when getting insurance for our lives?

4. You're right. Insurance companies can calculate the odds that you'll lose your home, wreck your car, or get disabled. Chances are slim. But what are the chances that you'll die? So, the question changes from "if" to "when". And correct, you can lose a lot of money, if it is not utilized correctly. Life Insurance, can be a tool of production and not just an expense.

[FMF]

Sow --

I think you're trying to NOT understand the issue just to make a point of some sort, so I'm passing on addressing your questions. If you REALLY want to know the answers, work on them with Google.

[Tabuxander]

Do I need to calculate and make a decision alone or should I discuss with financial advisor and let him calculate for me?

Great article anyway.

[FMF]

Tax --

I did it myself, but if you don't feel comfortable on your own, by all means get some help.

[water damage restoration]

I'm looking into getting life insurance now but want to provide for my family well above 7 times gross income. Is it hard to get an insurance company to write a policy for 15-20 times gross yearly income? I'm in my early thrities and in good health. Please get back to me, thanks!

[Aaron @ Clarifinancial]

I love the introduction of this article. Too many people buy the wrong amount of insurance because they focus on the type of insurance and get it wrong. If consumers stay focused on their goals instead, the type of insurance won't come into play until very late in the game.

@Water Damage It sounds like you intend your life insurance to replace a good part of your income. For someone your age, this is a common goal. Most life insurance companies will not have a problem issuing up to 20 times your income for this purpose. However, run the calculation, you may not need quite that much. Many insurance agents use this exact same method.

[Tyler]

this was a great article, very informative. I have been speaking with a rep. from a company (I'd rather not mention the name) and he advised that I get 10-15x my annual income in insurance, you said 7x, so is this guy just trying to make a bigger commision off of me or is he actually doing something good?

[MikeS]

Tyler - I would want to know the math behind the 10-15x income, it is possible its right.

I'm 34 and I've got about 22 times my salary. As I've got very little savings right now, my need for insurance is greater. My wife is a SAHM with our 2-yr old daughter, so we needed to replace the majority of my income. If your spouse works, you might need less than I do. It really depends on each persons individual situation.

[Jessica]

Great article. I want to get life insurance as i am a SAHM as well, but my husband has several investments plus his 401K that he thinks will be sufficient in lieu of life insurance. While the amount right now is pretty high, it seems risky as the ultimate number depends on the market at the time. Plus, I would get taxed on that in the event I need to tap into it correct? What are your thoughts on this avenue?