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.

J.D.'s note: I said this over the weekend, and I'll say it again: Permanent life insurance (such as whole or universal) is not a bad idea for everyone. For some folks, it absolutely makes sense. But for the average joe, term insurance is usually the best option.

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.

Example: Mary and Fred both have good jobs and will continue to work if one spouse dies. They've decided that they'd like to have enough insurance to cover the mortgage. The mortgage is $300,000 so they decide to get $200,000 of insurance for 10 years and $100,000 insurance for 20 years. The idea is that they will have paid down the mortgage enough in 10 years that they don't need the original $300,000 amount anymore.

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.

Example: John and Sue are in their 30s, have two kids under five, a mortgage of $300,000, and other debts equaling $40,000. Sue is a stay-at-home mom who might return to work one day. They've decided that if John dies they want to have enough money so that Sue doesn't have to work again if she doesn't want to, but she won't be filthy rich. They're assuming that $40,000 of income per year will accomplish this goal. They have no savings of any type. Step one: Add up the debts = $340,000 insurance needed. Step two: Calculate the portfolio size necessary to provide $40,000 per year. $40,000/0.04 = $1,000,000. Total insurance needed is $1,340,000.

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?

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Don't get hung up on details. It doesn't matter how accurate your estimate is because things will change and then you'll be over- or under-insured. I did a case study on myself only a couple of years ago where I went through the process for determining how much life insurance I needed. Things have changed so much in the last two years for me (I can't believe how much) that I'll have revisit this calculation: We have two kids now, our debt is less than half of what it used to be, my business is doing extremely well, and I don't think I'll keep my day job as long as I'd originally thought. (I get a lot of my insurance through work.)

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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