How much life insurance do I need?
Preparing for unexpected catastrophic events
Do I need life insurance?
There are many different types of unexpected events in our lives, and they require separate solutions from a planning standpoint. Preparing for disaster is not fun, but it’s a crucial piece of your overall financial plan. In the financial planning world, we do something called a “stress test” that looks at a variety of unexpected events and what changes might be made to prepare for them. The “big four” events that most people should prepare for first are: a loss of job or career, unexpected medical expenses, stock market crash, and death of a loved one. If you have a plan in place for these four events, then you can start to branch out and build in some preparation for other circumstances that might not be as pressing. There are many ways to mitigate the risk to your belongings, property, and livelihood, but I would suggest focusing on the “big four” first, then expanding into other types of protection.
Emergency funds help us prepare for the first two events of the “big four”: job loss and medical expenses. But an emergency fund is far too little money to help prepare for what is often the worst possible moment in someone’s life: the death of a spouse or other family member. To prepare for the unthinkable, we need a tool to mitigate our risk, and that means insurance. More specifically, life insurance. Not everybody needs life insurance, but most will at some point during their lifetime. Purchasing life insurance is a money milestone that comes and goes during your life and is critical at certain times and a potential waste of money during others. I’ve worked with many widows throughout my career, and the security provided by a life insurance policy can really help bring some calm and security to an otherwise tragic period for the family. Financial stress during grieving is something that nobody should have to deal with.
Would your death cause your family or your dependents financial stress? That is the only question that needs to be asked when considering a life insurance policy. If you are 65 years old, with 1.5 million safely tucked away for retirement, and your kids have graduated from college and have their own careers, you don’t need life insurance! Similarly, a 20-year-old single college student likely does not need life insurance. Life insurance is meant to provide for your family and replace the income that you would have been providing them if you were alive. Life insurance is most useful for people with young children at home and/or a spouse or other family member dependent on their income. That tends to be people in the 25–50 years old bracket, but it does not have to be, and it really depends on your personal situation. If you are financially well off and near retirement, your family is going to inherit all your assets anyway, so you are likely just wasting money each month on an insurance policy. Further, life insurance policies are much cheaper if you are younger and statistically less likely to die unexpectedly.
How much life insurance do I need?
Life insurance offers peace of mind and helps to ensure that your debts and loved ones will be financially taken care of in the event of your death. But before considering your purchase, you need to decide on how much you need. Calculating your life insurance needs is often an elaborate process, with the insurance industry using a series of complex formulas called the “human life approach” and “needs approach.”
Some of these approaches are complicated, and not surprisingly tend to overvalue how much you really need. I prefer a simpler approach, based on a few criteria: your income and living expenses, debt and remaining mortgage, funeral expenses, and future college savings. So, let’s consider an example:
Madison and Justin are both 30 years old and married with two young kids, ages seven and three. Madison is employed at a local accounting office and makes $40,000/year, and Justin is a contractor that makes about $50,000/year. They owe $140,000 on their mortgage, have $3,000/month in living expenses, and have plans to send both of their children to four-year public universities when they are older. How much life insurance should Justin carry to help protect his family if he were to die unexpectedly?
To estimate your life insurance needs (LIN), simply use the following formula:
LIN = funeral expenses + remaining debt and mortgage + cost to fund education + living expenses until both children are 18 or ten years, whichever is more.
Applying the LIN formula to Justin, we get ($10,000) + ($140,000) + ($152,000) + ($540,000; $3000/per month for 15 years) = $842,000 in life insurance needs. You may have noticed that I recommend paying for all living expenses, even though Madison is paying for a large portion of their expenses. Losing a spouse at a young age can be a devastating event, and many people will want to take time off work to recover and might need to spend more time at home caring for their family. By covering all living expenses for at least ten years (or until your children are 18), there will be a long-term security for the family and less added pressure to go back to work immediately.