Exploring Why You Need Life Insurance and How Much You Need

The following is an excerpt from The Questions and Answers on Life Insurance Workbook: A Step-by-Step Guide to Simple Answers for Your Complex Questions. Since this is a workbook (meant for you to fill in sections of it), you can't get the full meaning/impact in a basic blog post. But I think you'll get most of the key ideas.

Following are a number of scenarios or life situations that support a need for life insurance. Put a check next to the descriptions below that best correspond to your needs for life insurance.

1. I’m a primary breadwinner for my family. I have young children and my family is absolutely dependent on my income. If I were to die tomorrow, they’d be in big trouble.

2. I’ve got debt. I have mortgages, car loans, credit cards, student loans, or some other form of large, significant debt that I couldn’t burden my family or cosigners with if I passed away tomorrow. It would break them.

3. I don’t want to burden my family with the costs of my funeral.

4. I’m saving for my child’s or children’s private school or college education. If I passed away, the kind of education that I’d like to be able to provide my child or children would very well be out of reach.

5. I want to have an emergency fund.

6. I have a special needs child who absolutely depends on my income for his or her care, probably for the rest of his or her life.

7. I’m worried about estate taxes. I want my family to have liquidity upon my death to fund the estate tax liability.

8. I’d like to donate a sizable amount to charity once I pass, but I don’t necessarily want to significantly reduce the amount of my estate donated to heirs.

9. I want to make sure my heirs each get an equal share of my assets when I pass away.

10. I’ve got assets that haven’t been taxed yet (a tax-deferred retirement account, for instance), and I don’t want my family to be burdened with those taxes, or for those taxes to reduce the benefit my family receives upon my death.

11. I’m in a second or third (or beyond) marriage or domestic partnership, and I’d like to provide my new partner with financial security; I want to avoid any conflict that may arise about my estate once I pass.

Looking at these scenarios, you can see that some are broader in context (the income-dependent ones) and some are much more specific (like the handling of estate taxes). Which scenarios best describe your situation will largely depend on how much in assets you have or can reasonably expect to have, what stage of life you’re in, and your personal family situation. Although these aren’t even all the reasons for purchasing life insurance, they do capture the most common motivations or reasons for purchasing it.

Determining How Much Life Insurance You Actually Need

Every advisor, financial columnist, and relative has a formula they think is best for determining how much life insurance you need. Some of these formulas are simple, whereas others look like something only a Wall Street numbers whiz could cook up. But don’t let complexity overwhelm or discourage you. If your needs are more complex, a qualified life insurance agent or financial advisor can help you determine the right amount for you. For most people, however, the simplest methods are often the best.

The simplest, most direct formula for determining how much life insurance you need is:

Income (replacement) + Expenses – Assets = Life insurance needed

The worksheet on the following pages will guide you through this equation. If you are interested in exploring other methods, information and resources can found on my website in the “How Much Life Insurance” section. Or you can refer to Question 3 in Questions and Answers on Life Insurance.

The best starting point for each of us in solving this equation is a simple, sound understanding of our own financial health. The more complicated we make it for ourselves, the better the chances are that something won’t work out as planned. Life is beautiful and dynamic. Ultimately, life insurance isn’t about reducing something as precious as life to numbers and figures; it’s about freeing us up to focus on what really makes us happy.

Note that even though you may already own a policy, it’s still important to complete this exercise. Why? Because your needs may have shifted as a result of certain milestones in life, such as having children, children graduating from college, retirement, changing careers, and so on.

For some people, this can be an emotional exercise. Just try to be as realistic about your financial health as you can be. The accuracy of any calculation depends on the information used. The more assets apart from life insurance you have, the more flexible your predictions about your life insurance needs can be. The fewer assets you have, the more you’ll need a reasonable, actionable forecast of your financial future. Don’t get hung up on the details you can’t reasonably predict—again, this is about making best guesses. Some of the questions in the worksheet may not apply to you.

Comments

[Old Limey]

Item 10
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If you leave your IRA to a young person such as a child, or preferably a grandchild, it becomes what is known as a Stretch-IRA. The young person will inherit the IRA and will have to make a mandatory distribution from it every year, with the size of the distribution based upon their life expectancy. The distribution will be taxable income. The younger the person is then the longer the IRA will last. This will increase their tax liability but also increase their income much more so it's a good way to STRETCH out the time it takes to deplete the IRA while providing income to the beneficiary for many years into the future, while making the government wait longer for their money, and allowing the IRA to keep growing after your death.

You also don't have to leave the whole IRA to one person, just make sure the percentages that are left to each beneficiary add up to 100%.

[Christa]

I like your simple equation for life insurance. Judging by it, we're covered should anything happen to my husband or myself.

[BZ]

We have Northwestern whole life insurance “key man” policies through a business that we own. It is a large expense now but in about 10 years it will pay for itself with its dividends. We view the cash value as our emergency fund and chose this vehicle because we were advised that our policy is judgment proof and bankruptcy proof in our state. I feel like it’s a good investment, but there are so many critics of whole life insurance that I sometimes doubt our decision.

[YFS]

Great primer on life insurance. Not many people speak about #7, 9 and 11. Thanks for including the estate benefits of life insurance.