How to Calculate the Right Amount of Life Insurance

Many people are intimidated by the thought of buying life insurance. Nobody likes to think too much about death, for one thing. And many people worry about which kind of insurance to buy – whole life or term life. But the most important question is how much you need.

The formula for this is pretty simple. It’s based on two parts:

  • How much income does your family need to replace your income if you’re gone?

  • What other expenses, like paying off a house or sending your kids to school, do you want to cover?

First, here’s a tiny primer on the kinds of insurance: term, whole or universal life.

Whole life insurance remains in place for your “whole life,” which is why it is expensive. Some people believe it also functions like an investment. You pay a premium, usually hundreds of dollars a month, for your whole life. Your beneficiaries will receive a payout if you die. In addition, the underlying policy will develop a cash value that you can withdraw.

Term life is simpler: It’s just an insurance policy. You pay an amount, usually less than a few hundred dollars a month for a set time or “term,” and sometimes much less. Your beneficiaries receive a payout – a death benefit lump sum – if you die during that term.

For purposes of this blog post, let’s focus on how much, rather than what kind.

We can assume, based on historic returns in the market, that any death benefit lump sum would produce a 3-5 percent return if invested prudently. For every $1 million in death benefit, a surviving family could spend $30,000 to $50,000 a year with reasonable safety while keeping the lump sum intact.

Add up your annual expenses and subtract other sources of income such as a spouse’s income (if it would continue past your death). This is the amount you need to produce each year. Divide this amount by, say 40,000 (assuming a fairly conservative 4 percent return) and multiply times $1 million. Add any future expected extra expenses to this amount. That’s the death benefit you want to buy.

Let’s run through the numbers with some assumptions. You make $60,000 a year and spend most of it to support your wife and children. Your wife does not work outside the home. Both of your children expect to attend college and estimated expenses for that will total $200,000 (they are near graduation, so you don’t need to worry too much about costs increasing dramatically in the next year or two). Using the above calculations, you would want a death benefit of $1.5 million to cover the replacement of your $60,000 income loss ($1.5 million x .04). Add in the estimated college expenses, and a policy with a death benefit of $1.7 million should be adequate. Once your kids have gone to school, you could revisit the question to see if you still need a policy that large – or one at all.

Many people do not need insurance coverage as they get older, because they have accumulated savings, which along with Social Security and other pension income, can support their needs. These people therefore may not wish to continue paying premiums.

In part because people are confused by the question of what type of insurance to buy, they can make mistakes about how much. One mistake I see often is the purchase of the more expensive whole life policy with an inadequate death benefit. Start with the basics: buy a policy with enough of a payout during the time you need it, and then decide whether you want to look at more complicated whole life policies with a cash value.

A CFP® professional can help decide what’s right for you.

Source: How-to-calculate-the-right-amount-of-life-insurance

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