On Friday, I shared a guest response to a reader question about life insurance. Many GRS readers rightly complained that it didn't do a good job of answering the question. One reader — Mike from Four Pillars and ABCs of Investing — took it upon himself to write this response.
One of the most common issues that people with any kind of dependents face is, "How much life insurance do I need?".
This is a tough question to answer in a simple equation; there are quite a few variables which affect the amount of insurance needed. First off, I'm only going to discuss term insurance. For most people, that's the only type of insurance to consider.
One of the key factors to consider is what kind of lifestyle you want your family to have if you pass away. How much financial impact will your death cause to your family? Do you want them to be filthy rich if you die? Do you want your partner to continue to work? Do you want them to be debt free? Is it important that they keep the same house? Will they be fine without any insurance?
The amount of insurance you might need/want will vary widely depending on your current financial situation. Let's look at two general situations.
Situation one: You want enough insurance to cover a specific use and don't need any insurance to provide future income for your spouse.
This might be the situation where both spouses are working and making decent money and have no kids. In that case, they might decide to get enough insurance to pay off all debts, at which point the survivor should be fine since they'll keep working.
This calculation is pretty easy. Just add the amounts of debts and whatever other costs you want covered, and that's how much insurance you need. The problem, of course, is that the amount of debt you have now and the amount of debt you have in 10 years will be quite different. (Hopefully, you'll owe less in 10 years!)
There isn't a lot you can do about this other than buy different terms of insurance. For example, you might buy $100,000 for 10 years and $100,000 for 20 years. You can also cancel insurance at any time, so one strategy is to insure for the entire amount necessary and, if you end up debt-free, then just cancel the insurance. Life insurance needs are very inexact so sometimes you just have to pick a reasonable amount and go with it.
Situation two: You want insurance which will provide future income for your spouse/kids.
This is a bit more complicated since you're now dealing with a lot of future assumptions. Regardless, for this situation an incorrect amount of insurance is a heck of a lot better than no insurance at all, so let's continue.
In this case I'd suggest that you start with all current debts and assume you need enough insurance to cover that amount. That's the first part of your insurance needs. The second part will provide an investment portfolio large enough to provide the desired annual income. To do this calculation, you can use the 4% withdrawal rule to be conservative.
The amount of insurance you buy will be the sum of these two numbers.
You can see from this example that future income is expensive! Using the 4% rule is fairly conservative. You might want to consider using a 5% or even 6% rule if the income needs are for a shorter term (i.e., if the insurance is only to cover a 10-year income gap before retirement age).
Other facts to consider when looking at future income:
- Retirement savings. If a couple is in their 50s and has a good retirement portfolio built up then the survivor might only need income until they reach 65 at which point they can live off the retirement savings.
- Pensions. This is probably more applicable to older people, but if Social Security and/or other private pensions are in the not-to-distant future then they should be factored in as well.
In summary, ignore all rules of thumb and insurance salespeople, and sit down to figure out how much insurance you need/want. Think about what it would be like financially if you or your spouse died and there was no insurance. Think about what you would like things to be like financially, and calculate how much insurance is necessary to fill the gap. Another approach is to pick specific insurance amounts and then apply those amounts to your situation. For instance, if you had $500,000 of insurance and you died tomorrow, what would your spouse do with the money and what would their financial life be like?
Post continued below ...
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Too much insurance is expensive. It's easy to just get a large amount of insurance (just to be safe), but the reality is that if you are over-insured, then you're paying a lot of extra money over 20 years. Plus, you don't want to give your beneficiaries any extra incentive to bump you off! :)
J.D.'s note: Another way to come up with a coverage amount is to use this handy online calculator from the nonprofit LIFE Foundation.
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Thanks Mike! I was confident that follow-up would be swift and substantive. This is exactly the method I used to calculate our term life policies.
2 spouses, both working and content to continue so, each of whose incomes would cover current expenses once debt payments are out of the picture …
$40k in debt … (it’s less now!!)
$30k in annual rent/utilities …
$30k to replace 3 old vehicles with one primo new one …
= $100k to get the surviving spouse financially free and clear and in a position to move forward with life; after, of course, a year of devoted mourning.
This amount of coverage is extremely affordable for most people and provides that little emotional security blanket many of us need.
Many banks offer term life “group” policies for accountholders that are very inexpensive; mine through Union Bank is $13.70/mo. Also, it can sometimes be less expensive to buy two small policies than one big one, but sometimes the reverse is true. Research is your friend.
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Great look at life insurance. I was talked into life insurance by my agent (whom no longer is my agent) and I felt like I bought way to much. The stress my agent put on me was to get my wife and kids enough money so they would not have to worry for a number of years. Somehow I was a bad father for not having a lot of life insurance. Which was way too much for our budget and needs. Thanks for making it clear that we can have different ideas about life insurance, and it is okay.
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Thanks for the posts on the insurance topic. We’re running through this now, so it is nice to read a bit of different view point than what the Insurance Salesmen want to sell. (Of course, selling is their job!)
We’ve come up with our own numbers and durations, less than the sales team’s numbers. We tried to take in to account mortgage, child care, college funding, living expenses, etc.
Of course we _want_ the seven figure payoff if one of us dies, but is that really right? Do we want to pay the monthly now for that eventuality?
If I am gone, I want you to be comfortable, but not so comfortable you are trying to bump me off before my time.
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Don’t forget to insure a SAHP– the services provided will have to be replaced at market value.
Though, to be honest, we just used a heuristic from some online thing… enough insurance to replace 10 years of income for a term of 25 years or something like that. The future is so uncertain that getting anything more fine than that didn’t seem worth the time. We satisficed when our son was born so that we would actually have insurance… if we had tried to optimize, our life insurance probably would still be in the same situation as our wills, that is, non-existent.
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I think the other issue to perhaps consider for a future post topic is disability insurance. The likelihood is so much greater that one of us will be disabled than the likelihood that one of us will die. So, we looked into disability insurance. This is something to look into especially if you have a highly specialized (and highly paid) job that you would not be able to do if you become disabled.
Just another thing to think about that goes along with this topic. Again, as with all insurance, something that you need to really investigate before you start to buy.
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Great follow-up post, like having specific guidelines. (and the calculator provides some great starting points for discussion).
I second Sashie’s (#5) comment that disability insurance would be a great topic. Seems like most people don’t think of getting disability coverage, which can be surprisingly expensive – yet more people and families are likely to benefit from disability insurance than life insurance.
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A welcome, well reasoned approach to coming up with a number. For me its still $0, but I have some through work regardless. When you are single, without debts or children the question is much simpler.
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Nice article, and a good follow-up. I’m with Sashie in that I *think* I understand the term insurance thing, but I honestly don’t have my arms around disability insurance. I’d like to find out more specifics (is there a term policy, what does it cover vs. what’s not covered, etc).
JD, I’m glad you’re back and I’m glad you’re done w/ the book. The comments on some of the past few posts seemed a bit off-base while you were gone. I look forward to reading your new book, but I look forward to your daily GRS posts more
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I first started looking at term-life insurance when I was 25. I actually found out the rates for 10 to 30 yr terms don’t change much from age 25-35. Therefore, to have life insurance until age 65, getting a 10 yr followed by a 30 yr term is MUCH cheaper than a 30 followed by a 10.
That’s what I observed, at least.
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Mike, thanks for the post.
JD, I’d also vote for another disability post!
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Thanks for posting this. It’s a topic I really know next to nothing about, and this was a good primer for understanding why my family needs life insurance and how much we should have. I’m confused about how this relates to the life insurance policy my husband has through his work. Is that a term policy?
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Big improvement over the last guest post, but this one (and the calculator) STILL ignore the issue of SSI survivor benefits. Come on people! This is potentially a major source of income for families with minor children who suffer the death of a wage-earning spouse. Why is everyone ignoring it? Am I missing something here?
I can’t get on the social security site at the moment, but it looks like there is a whole publication devoted to the topic. If this is not required reading for insurance agents, it should be:
http://www.ssa.gov/pubs/10084.html
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As far as Social Security survivor benefits go, I know someone on the last post made a comment about getting a lot if you have many kids. HOWEVER, on my social security statement it clearly says the maximum family benefit is only 2x the individual survivor benefit. In other words my family would get the same for a wife and 2 kids as a wife and 1 kid. It reads spouse $XXX, child $XXX, maximum family $X,XXX ( which is wife+1 child).
I agree that it can be a significant source of income, though. At least temporarily. Keep in mind it will drop by 50% when a child turns 18 even if the child is a dependent college student.
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My preference would be enough money so that my spouse would never have to work again and children would make it through college,etc. I understand people who don’t consider these things necessary. However, it really depends on individual circumstances.
For example, my spouse does not work now. She hasn’t earned income in a few years and has never earned significant income in her life. Despite being intelligent and capable and doing all the traditional “right” things ( graduated from college with high honors), she has never had much opportunity. I don’t see it getting any easier as she gets older and more removed from traditional work. Let me correct that. She does a LOT of work. She just does it for our family and no paycheck. She does the work that works best for us. If she got a job it would hurt our family in many ways. I’m sure when the kids are grown and if I’m still around, she will want to find something to do outside of the house. If I die before the kids are grown it will be impossible for her to be employed. The Social Security benefit would help but wouldn’t cover bills.
So if I am able to leave my family money, I would be happy to. The question is whether that is funded by insurance. At this time I do not have high 6 or 7 figures in cash. If I ever do, like most people, my net worth and income will probably peak when I am older ( and kids are grown). For now if I want to leave them a significant amount it’s through inexpensive term insurance.
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I think too often people also forget to add funeral expenses which can be upwards of $5000-10000 or more. This is yet another important reason to have life insurance. Also our situation closely resembles the 2nd scenario except we dint have a mortgage. So it’s also important for the stay at home parent to at least have a small policy to cover funeral expenses and daycare that the existing parent would need after the partner’s death.
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I sell life insurance as an agent for the largest P&C insurer in the US.
I constantly stress it isn’t about dollars. It is about WHAT DO YOU WANT YOUR LIFE TO LOOK LIKE IF SOMETHING HAPPENED TONIGHT?
Would your spouse go back to school? Move in with mom? Sell the house? Want to work part time until the kids are 15? There are NO WRONG ANSWERS!!!! ONLY YOUR ANSWERS!!! You would be amazed at what you learn about your spouse when you sit them down and say “if I was killed in a car wreck TONIGHT what would you want your life to look like??”
Most of you don’t know.
Once you know what you want your life to look like then we price it out.
Then we look at budget and time frame and you make a decision as to what works.
Simple formulas or ratios of income are not sufficient.
BTW if you have not explored return of premium term you really should. Our policy pays back 100% of premium if you outlive the policy. Return on the cost of the rider is usually 4 -5 % tax free (we are only returning premium… so NO taxable gain) which can be decent when you convert to a taxable equivalent.
Ric
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Great post. My life insurance allows my spouse to keep the principle in effect for 30 years after I pass while living off the crediting rate of 5.14%. It has been that rate for a number of years. (example: on a million bucks, the income would be $51400/year-taxable, with a lump sum payment of the million tax free at the end of the 30 years or to our child if she were to pass before then.) Ask if that is the case with a prospective insurance policy.
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Great post. My wife and I are still trying to figure out how much we really need (we don’t have kids so really its more to support each other in case something happens).
I definitely think its a tough question to answer because it depends on lots of factors- are both spouses/parents equally able to support the family? How old are your kids? What’s your current income level, and do you want your family to have just enough to scrape by or basically retire?
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While it is important to get value for money I sure no spouse would complain that their deceased partner had too much insurance.
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What about taxes? When I originally signed up for life insurance several years ago, I thought my spouse would have to pay taxes on anything over $500K, so I had to take that into consideration on how much to get in my policy. Has that changed? Was I wrong before?
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I bought what I could afford at the time. I was banking on Social Security death benefits kicking in if I died. The SS death benefits would tide my wife over if I were to die back then.
Now since we have 2 kids, and college off in the distance, I up my coverage to 1/2 a million a few years ago.
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Thanks Mike for the simple formulas. Of course as you (other commenters) have said, there’s much more than just picking a number.
Is there more in formation concerning when you need insurance vs when you could hold out. Like younger without kids or older and close to retirement or in retirement?
JD, Thanks for keeping your head when all about you were losing theirs.
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Just a thought… it may be less expensive to buy one larger policy than two smaller ones. When we went to get insurance there was a very small difference in premiums for $100,000 vs $200,000 benefits. I haven’t done the math, but I’m going to guess that you’ll pay a lot more to get one 10-year policy and a second 20-year policy. And like the commenter above said, no one’s ever complained about getting “too much” life insurance after a loved one passes.
It’s okay to ask for multiple quotes from your insurance agent! We asked for three different scenerios with multiple term lengths and benefits, and chose the one that worked best for us.
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JD,
Please mention how you can “double” your life insurance by setting up a living trust instead of a will. This may have some upfront costs but the money can be transferred tax free and will protect anyone from viewing the assets of the estate.
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It is not always possible to get term life insurance. If you have an illness, as in our case where my husband has juvenile diabetes, it is impossible. We got him a whole life policy when our children were very small (actually, before the last one was born) and have paid a large premium on it every month. At 62, he is extremely healthy, except for being chronically ill, but it makes no difference. The insurance company is now trying to talk us into letting the policy lapse, for no very good reason that I can see except that since he hasn’t died they are not getting as much profit on it.
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There are a few major variables you can’t exclude when calculating the amount of insurance needed; inflation, health care costs, & college/grad school tuition (if you have kids). 20 yrs down the road that $500K will be worth closer to $200 or $300K. Also, based on the rate of tuition increases these days there is no way $500K will even begin to cover a 4 year private college. Lastly, as everyone has experienced care costs are skyrocketing and the survivor may/may not have coverage.
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Thanks for all the kind comments!
Is there more information concerning when you need insurance vs when you could hold out. Like younger without kids or older and close to retirement or in retirement?
@CB – I think in those two scenarios you might want to play “what if?” and visualize what it would be like if one partner died tomorrow with your existing insurance coverage (which might be zero). Will the funeral costs be a burden? Will there be help from relatives? Can the survivor maintain their standard of living without their partner? (assuming that is what you want). This might tell if you if “holding out” is an option.
As others have mentioned, term insurance isn’t all that expensive so for someone who is kind of on the fence about needing insurance might want to consider a small policy. I’m not sure if there are minimums policy amounts, but for some situations $50k or $100k might go a long way to help the situation without busting your budget.
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Ric mentioned Return on Premium Term Life Insurance in in #16, but I haven’t seen any other info on it.
Return on Premium means that if you outlive your policy term you are refunded all of the premiums you paid. I took out a 30 year ROP term policy at age 26. At age 56 if I outlive the policy I get a check for the 30 years of premiums I paid. It is more expensive than regular term, but it is a great option if you are younger and fully expect to outlive your term life insurance. The normal insurance quote sites list the policies; I found mine through insure (dot) com.
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It’s also a good idea to discuss this with your spouse. My spouse doesn’t think he could afford the mortgage without me, but he ALSO doesn’t want to stay in our house without me. This reframes the question from “need enough money to pay off the house” or “need enough money to replace income” to “need enough money to pay the mortgage for a year or two while he’s getting himself together enough to sell.”
That much? We already have in savings/easy-to-access investments.
(We have no children.)
Oh — and funerals? Another good thing to discuss beforehand, too. My mother chose (and prepaid) cremation, but the funeral folks were quite willing to sell us a fancy casket and embalming package if we wanted a “viewing”. Fortunately they took “No, thank you” very gracefully.
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Good post on a difficult subject. The problem for most folks is the person who should be most knowledgeable and helpful on the subject has a financial stake in getting us to buy the product. So, as customers we are naturally distrustful. Most important thing for folks to do is to periodically review their coverage and life situation.
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I feel like this is a touchy with most people and I know many that don’t even want to discuss their insurance with their spouses.
However, one thing is for certain:
“Ignore all rules of thumb and insurance salespeople, and sit down to figure out how much insurance you need/want.”
They make their money selling you more insurance than you really need.
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Re: funerals, I don’t really know – no personal experience – but isn’t there sometimes a significant delay in receiving a life insurance benefit? So you might want to have funeral expenses saved up in actual liquid cash, and not include that in calculating your life-insurance needs.
Or just go the way I plan to – whole body donation to the local teaching hospital. No muss, no fuss.
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My job gives me life insurance, but I don’t need it, as I am single and childless, and since I am now in by 50′s expect this to be permanently true. (My parents have passed, and my siblings are financially independent.) I wish I could take the money they spend on life insurance and use it, say, to buy additional vacation days. My previous employer set up “flexible benefits.” You got a benefits allowance and decided how to spend it. For example, those with families could opt for more life insurance, single people for less. You could also buy up to 5 additional vacation days, or sell them up to a point. Any extra money would be put in your paycheck (over the course of the year). If you spent more than your allowance, the extra would be deducted from your pay, likewise over the course of the year. I realize this is somewhat off-topic.
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@Dave #20: Death benefits are received income tax free. Currently, there is no estate tax although that will almost positively change once Congress enacts legislation or simply does nothing. But even then, life insurance will pass tax free to your spouse.
@Stacey #23: Every term policy has a policy fee associated with it usually between $50 and $75. Other than that, the rates for insurance will usually be proportional. So two policies for $100k each will cost the same as one policy for $200k plus the additional policy fee. Insurance companies usually have “bands’ where the cost of insurance is reduced once you start buying larger amounts.
@PB #25: You’re right. Sometimes it’s difficult to get insurance due to medical conditions. But depending upon if your husband’s diabetes is controlled it might be possible. Work with a broker experienced with “impaired risk underwriting”. You might be surprised.
As this great article suggests, there are many factors involved in determining the right amount of insurance. What’s scary is right now $1,000,000 of life insurance would create around $40,000 of annual income without going into principal. Lower interest rates might mean you need to consider a larger amount of insurance. We have a tool on our website that can help figure out the right amount. Unless you specifically request the info to be emailed no information is captured.
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Thank you, JD for acknowledging that Permanent Insurance is appropriate for some people. I have both term and permanent. I will die, for death is certain, just not during the term of my term insurance. For me, the permanent policies are to make sure that my estate is unencumbered by debt or the expenses of my death and my heirs can continue to derive cash flow from the investment properties I am leaving to them. This has been an awesome discussion. I do have disability insurance. What I can tell the folks asking about it. DI is twice as expensive for women as men. I have a very clear understanding as to why this is and it is a pet peeve of mine.
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We made the right decision for the wrong reason. As a dual income couple planning to have children, permanent life insurance was affordable. In the late 1980′s, permanent life insurance dividend scales were at a historical high and projections showed that dividends would pay the entire premium in 10 years.
From 1987 on, except for a handful of years, the dividend scale went down every year. As a result the 10-year projection has taken 23 years to achieve. Talk about not being able to predict the future!
However, our first and only child has a seizure disorder and is autistic. He is almost 15 years old and cannot read or take care of himself without supervision and may never hold any type of job. If it is not obvious, I consider that a permanent need for life insurance. My wife and I are so thankful that we diversified our investments and included significant amounts of whole life insurance in our portfolio.
I agree that whole life insurance is not needed by most people. However keeping the option open is a good idea and not that expensive. Don’t buy the cheapest term for all your insurance. Purchase some or all from an investment grade insurance company that has a conversion feature. A conversion feature gives the ability to purchase permanent insurance at standard rates. Most experts consider this feature to be second only to obtaining the total amount of life insurance that you need.
Getting the right coverage at a price you can afford is the number one priority. In addition, make sure it is a financially strong company and seriously consider a policy with a conversion feature that gives you a guaranteed right to purchase permanent insurance at standard rates.
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This is certainly a fantastic discussion on a difficult subject! I am an insurance agent for one of the larger property and casualty insurers, and we of course offer life insurance policies as well.
The first thing I would ask the general public is to not necessarily knock the advice of your local agent. Many are well versed in the various aspects of the multitude of policies available, plus they have an interest in making sure you are properly covered. This interest is more than financial, by the way! Most agents make their living not by one policy, but by the relationships forged over years. Therefore doing what is right by each client is paramount. Enough of my soapbox…
As many have said, there is no one absolute number. Every client I advise has a different amount in mind, so we work through a simple question: “What do you want the beneficiary to do with the money once you are gone?” The answers range from paying off the mortgage, to putting kids through school, to giving money to a beloved charity. Once the needs (or wants) are known, the calculations are easier.
I love the reference to the non-profit LIFE Foundation. They provide some great information for consumers.
Lastly, I agree that permanent insurance is not for everyone, but I dislike hearing some saying absolutely that permanent insurance is bad. There are definitely situations where these policies provide vital monies for a family’s needs.
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I went with the option of insuring for the mortgage plus a little more. While this isn’t the same as replacing an income, paying off your mortgage entirely opens up a huge amount of cash flow and removes the pressure of working for that amount of money.
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You said:
“Think about what it would be like financially if you or your spouse died and there was no insurance. Think about what you would like things to be like financially, and calculate how much insurance is necessary to fill the gap”.
Life insurance is income tax-free cash that is placed in the hands of someone you love at exactly the time when they need it the most.
When a beneficiary receives a lump-sum payment from the life insurance company… I seriously doubt that they ask if it came from term, whole life, universal, or any of a number of fashionable hybrids.
Many people want others to tell them what they should buy, but the generational impact that properly purchased life insurance has on families (and businesses by the way) is profound and requires an honest evaluation of all emotional and financial circumstances.
Sometimes, this is not an easy task because so-called financial professionals do not truly understand what is at stake… unless they have experienced it themselves.
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My concern is what is the eligibility of a person for taking life cover for eg. if a person earns $84000 per year how much maximum life cover can he take. and also is this limit applicable on the total life cover taken from different insurance companies??
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