Life is full of uncertainty. When it comes to financial planning, life insurance needs to be a priority. Although it is not an enjoyable topic, death is inevitable for all of us. If you have loved ones who depend on your financial support, however, then you need to make sure you have a plan in place to take care of them in the event you should pass.
Life insurance can cover funeral expenses, be used to pay off debt, and ensure your loved ones have the means to cover normal living expenses without worrying. If you’re like most people, you may be asking yourself how much life insurance you need. Even if you already have a policy in place, it may not be sufficient.
A general rule of thumb I hear often is to take your income and multiply it by ten. However, that method really isn’t a method at all. I am honestly not sure where it comes from. Your individual and family situation are unique and your life insurance calculation needs a personalized approach. Because of the love you have for your family, this is one area of financial planning you don’t want to leave to chance.
While working with a financial advisor or insurance professional to model “what-if” scenarios is always the best option, there are some simple ways to arrive at an educated estimate of how much insurance would be enough for your family.
Just follow these five simple steps to calculate your life insurance.
Add up all your debt.
Determine a budget for living expenses.
Calculate the total of debt + expenses.
Factor in future costs like college for your kids.
Let’s investigate each step a little closer.
1. Add up debts to determine how much you’ll need to pay them off.
The first thing your life insurance policy should accomplish is to pay off any outstanding debts you may have. You don’t want to leave your loved ones with the responsibility or burden of lingering payments on debt. Add up your debts including your home mortgage, student loans, car loans, consumer or credit card debt, and any others. For the sake of example, let’s say this is $500,000.
TOTAL DEBT PAYOFF AMOUNT NEEDED: $500,000
2. Determine a budget for all living expenses after debt is paid off.
Once you’ve factored in the cost of debt, come up with a budget based on everything else your spouse would need to continue living the same lifestyle without having to make sweeping changes. Make sure to include any current and future childcare costs and/or the costs of private schooling if this is your reality.
Once you arrive at this number, divide it by 0.04. That is, assume a 4% withdrawal rate. If your surviving spouse can invest these funds in a moderately conservative manner, assume he or she can withdraw 4% without depleting the principal of this life insurance death benefit amount.
Using our previous example, assume the surviving spouse would need $5,000/month once all the debt is paid off. This is assuming this surviving spouse is a non-working spouse or would like to make the decision to not have to work in the unlikely event of your passing. This is $60,000/year. Divide this by 0.04 and you arrive at $1,500,000.
MONTHLY INCOME NEEDED: $5,000/month, or $60,000/year
$60,000 / 0.04 = $1,500,000
3.Calculate the total of debt + total of expenses.
Now, you want to add up the total amount you calculated based on your monthly expenses and the total amount of debt you’ll need to pay off.
TOTAL AMOUNT NEEDED TO COVER MONTHLY EXPENSES: $1,500,000
TOTAL DEBT TO PAY OFF: $500,000
$1,500,000 + $500,000 = $2,000,000
4. Factor in future costs like college for your kids.
College is expensive, and without a plan, in place, your kids may end up with student loans to cover the costs. You can factor in the cost of college when determining your life insurance amount. While college may be off in the future, we will use today’s figures to calculate the cost because we can invest this money for them to keep up with inflation.
Let’s say you have two kids and college costs around $30,000 a year for four years. You would need to have $240,000 to cover the cost.
$30,000 COLLEGE COST
2 X $30,000 x 4 = $240,000
Based on all the information we gathered, your life insurance policy would need to have a death benefit amount of $2,240,000.
$2,000,000 + $240,000 = $2,240,000
This would create a comfortable scenario for this surviving spouse to not have to feel the pressure of having to return to the workforce in order to make things work.
5. Bonus: Create a buffer for childcare if the surviving spouse chooses to work.
The death benefit amount we calculated above covers every cost so the surviving spouse would not have to work. However, the surviving spouse may decide to work anyway, or continue working. If that’s the case, you may want to add an extra buffer for the cost of childcare. Use the above example to determine the gap between living expenses and income to arrive at this number.
For example, if childcare costs $1,000 per month or $12,000 per year, and you anticipate 15 years of needing that amount, then add it all up.
$12,000/yr x 15yrs = $180,000
Assume your surviving spouse can generate enough income to support lifestyle ($5,000/mo in our example), then we would still need to pay off all debts, maintain the above budget for childcare costs, and fund your children’s higher education expenses. Additionally, you might provide a buffer of retirement savings so that is one less thing your surviving spouse has to worry about as he or she goes about providing an income for the family.
Nobody wants to think about death, but preparing for it properly can ensure your family is taken care of. Talk with your financial advisor to determine how much life insurance you need before you purchase a policy. Don’t leave it to chance when it comes to getting this number right. When you get it as close to right as possible, it could be the difference between your loved ones struggling or thriving in the years to follow.