How much life insurance do you need? What type is appropriate? You should review your life insurance needs each time you have a major life event. Here is what you need to know to properly plan for your life insurance needs to buy enough and to get the most for your money.
Table of Contents
- Do You Need Life Insurance?
- How Much Life Insurance Do You Need?
- Types Of Insurance
- How Insurance Products Differ
- How To Shop For Insurance
- Shopping For A Policy
The prospect of planning for your family’s life insurance needs may seem daunting. The array of confusing products available, coupled with the calculations needed to find the right amount of insurance, would put anyone off.
Yet the hard fact is that life insurance is an essential part of your family’s financial well-being. The more you know about it before you go to your agent, the better your coverage will be. If you don’t plan for your life insurance needs, the result could be a waste of thousands of dollars on inappropriate or ineffective life insurance or, worse, financial hardship due to not having enough insurance.
This Financial Guide gives you some basic guidelines about whether and when you should purchase life insurance, and provides you with a system for determining how much you need. It also discusses the types of insurance available, their suitability for various situations, and how to comparison shop for a policy.
Do You Need Life Insurance?
The purpose of life insurance is to provide a source of income, in the case of your death, for your children, dependents, or other beneficiaries. Life insurance can also serve other estate planning purposes, such as giving money to charity on your death, paying for estate taxes, or providing for a buy-out of a business interest. These will not be discussed in this guide, however.
Related Guide: Please see the Financial Guide: ESTATE PLANNING: How To Get Started.
Whether you need to buy life insurance depends on whether anyone is depending on your income. If you have a spouse, child, parent, or some other individual who depends on your income, you probably need life insurance. You might also need life insurance for estate planning or business succession planning purposes.
Here are some typical insurance situations along with typical insurance needs:
Situation 1: Families or single parents with young children or other dependents
The younger your children, the more insurance you need. If both spouses earn income, then both spouses should be insured, with insurance amounts proportionate to salary amounts. If the family cannot afford to insure both wage earners, the primary wage earner should be insured first, and the secondary wage earner should be insured later on. A less expensive term policy might be used to fill an insurance gap. If one spouse does not work outside the home, insurance should be purchased to cover the absence of the services being provided by that spouse such as child care, housekeeping, and bookkeeping. However, if funds are limited, insurance on the non-wage earner should be secondary to insurance on the life of the wage earner.
Situation 2: Adults with no children or other dependents
If your spouse could live comfortably without your income, then you will need less insurance than the people in Situation (1). However, you will still need some life insurance. At a minimum, you will want to provide for burial expenses, for paying off whatever debts you have incurred, and for providing an orderly transition for the surviving spouse. If your spouse would undergo financial hardship without your income, or if you do not have adequate savings, you may need to purchase more insurance. The amount will depend on your salary level and that of your spouse, on the amount of savings you have, and on the amount of debt you both have.
Situation 3: Single adults with no dependents
You will need only enough insurance to cover burial expenses and debts unless you want to use insurance for estate planning purposes.
Situation 4: Children
Children generally need only enough life insurance to pay burial expenses and medical debts. In some cases, a life insurance policy might be used as a long-term savings vehicle.
Situation 5: Retirees
There is less of a need for life insurance after retirement unless it is to be used for other estate planning purposes. You may need to provide an income for the second spouse to die if your retirement assets are not large enough. Further, you will need some insurance to pay burial expenses, final medical costs, and debts.
How Much Life Insurance Do You Need?
Determining how much insurance to buy requires you to invest some time in calculating:
- Your current annual household expenses
- Your assets, debts, and other sources of income.
We’ve provided a worksheet, which we will refer to in our discussion.
Find out how much insurance you need before considering which type of insurance to buy. Having enough is more important than having the right type. You should provide for your insurance needs immediately, although you can always switch to a more cost-effective or investment-oriented type of insurance later.
The ideal amount of coverage is the amount that would allow your dependents to invest the insurance proceeds after your death and maintain their desired standard of living without touching the principal. Although the old rule of thumb to buy five, six or seven times your annual salary may serve as a starting point, it is no substitute for making the calculations to find out how much you really need.
By using the worksheet and our explanations, you will be able to make a fairly good estimate of your insurance coverage needs. You will need to make some assumptions about your family’s future. It’s important to be as accurate as possible in filling out the worksheet since an underestimation could lead to your being underinsured, and an overestimation will lead to money wasted on unnecessary coverage.
Here is a line-by-line discussion of how to prepare the worksheet.
Line 1: Calculate The “Annual Income Needed”
Line 1 of the worksheet, “Annual Income Needed,” is the amount that your survivors would need to live comfortably. It is important not to underestimate this amount. If there are recurring expenses that your family incurs but that are not shown on the list below, do not neglect to include these.
To arrive at the “Annual Income Needed,” find the following amounts paid monthly. Then multiply the figure you arrive at by 12 to arrive at an annual amount. Add the following amounts:
| Expense | Your Estimate |
|---|---|
| Mortgage or rent, and other home-related expenses. Include your monthly mortgage payment, with insurance and real estate taxes, or the amount paid for rent. Also include monthly home repairs and home improvements, furniture, appliances, linens, and other household items. | $___________ |
| Heat, electricity, insurance (life, health, and liability), water, gas, trash collection, and other monthly bills | $___________ |
| Food, including groceries, drugstore items such as toothpaste, and restaurant bills | $___________ |
| Clothing | $___________ |
| Travel, including car payments, gas and oil, car repair, and car payments | $___________ |
| Child care or other dependent care | $___________ |
| Recreation, including travel, gifts, theater, and cinema | $___________ |
| Other | $___________ |
| Total monthly expenses | $___________ |
| Multiply by 12 and enter amount in Line 1 of the worksheet | $___________ |
Line 2: Subtract “Other Sources”
The next item on the worksheet represents the income that your survivors will have. If there are sources of income other than the ones listed, do not neglect to include them.
To calculate Social Security benefits, you may wish to obtain an estimate of your benefit from the Social Security Administration. You can obtain a request form by calling SSA’s toll-free number, 800-772-1213.
Since you cannot predict the amount your survivors will receive (it will depend on your age at death, your earnings, and the ages of your children), you may use the following as rough estimates: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16.
Do not include other insurance proceeds here; this will be accounted for later.
Line 3: Determine The “Shortfall”
Line 3 represents the shortfall, i.e., the amount you need your insurance proceeds to replace. This is determined by subtracting the “Annual Income From Other Sources” amount from the “Annual Income Needed.”
Line 4: Determine the “Amount Of Proceeds Needed”
Line 4 is the amount that will generate the investment income needed to make up the annual “Shortfall” in Line 3.
The amount by which you should divide the shortfall represents the after-tax rate of return you can expect on the invested life insurance proceeds. The amount you choose to divide by depends on how conservative you want to be. The original guide suggests using a four percent, five percent, or six percent after-tax return assumption, depending on the level of caution desired.
The amount you arrive at is the amount of death benefit (proceeds) you will need. The amount will be further adjusted as you work through the worksheet.
Line 5: Add the “Lump-Sum Expenses”
These are the items your family will have to pay for at the time of death. They differ from the “annual income needs” amounts in that they are not part of the family’s everyday living expenses. Further, unlike the annual income amounts, they represent estimates. If you wish to strive for a higher rate of accuracy, you can try to adjust these items for inflation.
The original guide suggests estimating funeral expenses at no less than $5,000, adjusting the figure according to your wishes and those of your family.
The final medical expenses will depend partly on your health insurance coverage. You can estimate this amount by finding out how much your policy requires you to contribute per illness.
The guide suggests estimating estate administration and probate costs at 5 percent of your estate for simplicity. Your estate is the total value of your assets at death.
Federal estate taxes and state inheritance taxes depend on the applicable laws and thresholds.
The “emergency living expenses” amount can range from three to six months’ worth of family living expenses.
The “debts” amount represents debts that your family desires to pay off at your death. Normally, it does not include items that make up the “annual living expenses,” such as mortgage payments and car payments. However, if you decide that you wish to use insurance proceeds to pay off such expenses, then add in the amounts you estimate will be needed to pay off such debts.
As for future education expenses, the original guide suggests using an annual cost of $20,000 per child, per year, for the sake of simplicity.
Line 6: Determine the “Interim Insurance Proceeds Amount”
Subtract the “future expenses” on line 5 from the “proceeds needed” amount on line 4. This is the amount of insurance you will need to buy on your life. The amount will be further adjusted.
Line 7: Subtract the “Assets That Can Be Sold and Other Insurance”
For line 7, determine the amounts that represent assets that your survivors could liquidate to pay future expenses. Do not include any assets your survivors will be using to produce income that you included in “other sources.” Also, note that you should include insurance payments and pension death benefits here, and not on the line for “other sources.” This is because such proceeds will represent one-time payments and not sources of annual income.
Line 8: Determine the “Total Insurance Needed”
Subtract the “assets that can be sold and other insurance” on line 7 from the interim insurance proceeds amount on line 6. This is an estimate of the amount of insurance coverage you need.
Life Insurance Worksheet
| Item | Your Estimate |
|---|---|
| 1. Annual income needed | $_____________ |
| 2. Subtract other annual income sources | |
| Salary of surviving spouse and other family | $_____________ |
| Estimated earnings on investments | $_____________ |
| Social Security | $_____________ |
| Pension income | $_____________ |
| Other income | $_____________ |
| Total other annual income sources | $_____________ |
| 3. Subtract total of line 2 items from line 1 | $_____________ |
| 4. Amount of proceeds needed (divide line 3 by 4%, 5%, or 6%) | $_____________ |
| 5. Funeral expenses | $_____________ |
| Final medical costs | $_____________ |
| Estate administration and probate costs | $_____________ |
| Federal estate and state inheritance tax | $_____________ |
| Emergency living expenses fund | $_____________ |
| Debts to be paid off | $_____________ |
| Education expenses | $_____________ |
| Other lump-sum expenses | $_____________ |
| Total lump-sum expenses | $_____________ |
| 6. Interim insurance proceeds needed (add line 4 and total of line 5 items) | $_____________ |
| 7. Employer-provided group life insurance | $_____________ |
| Other life insurance | $_____________ |
| Death benefit from pension plan | $_____________ |
| Cash and savings | $_____________ |
| IRA, Keogh, and 401(K) plan lump sum amounts | $_____________ |
| Other assets that can be sold | $_____________ |
| Total assets | $_____________ |
| 8. Total insurance needed (subtract total of line 7 items from line 6) | $_____________ |
Types Of Insurance
Although the array of insurance products may seem confusing, there are really just two types of insurance: term and cash value, which is more commonly referred to as whole life, universal life, or permanent life insurance.
With term insurance, you pay for coverage for a specified amount of time, and if you die during that time the insurer pays your survivors the death benefit specified. Cash value, on the other hand, provides you with some other redeemable value in addition to paying a death benefit. For individuals age 40 or less, a term policy will almost always be less costly than a whole life policy. Although term policies do not build cash values, many are convertible to whole life policies without a physical exam. Thus, a term convertible policy may be a good option for someone who is under 40.
Term Insurance
There are various types of term insurance including:
Renewable. A renewable term policy renews automatically for a specified period, such as every year, every five years, every ten years, or every twenty years. You do not need to take a physical or verify the fact that you are employed. The premium goes up at the beginning of each new term to reflect the fact that you are older. Most renewable term policies can be renewed until you reach around age 70.
Re-entry. With this type of policy, you must undergo a physical exam after a certain period, or pay an extra premium.
Level. With level term policies, the premium is guaranteed to stay the same over a certain period. This period may be shorter than the term of the policy.
Decreasing. With a decreasing term policy, often used to insure mortgage payments, the face amount of the policy decreases over time while the premium payments remain the same.
Return of Premium. Some insurers offer term life with “return of premium.” Typically, premiums are significantly higher, and the policy must remain in force for the term.
Cash Value Life Insurance
There are four types of cash value life insurance: (1) whole life, (2) universal life, (3) variable universal life and (4) variable whole life. The first two types are the most common and may have guaranteed cash surrender values; in the last two types, the cash surrender value is not guaranteed.
Whole Life. This is the traditional life insurance policy. It provides a death benefit, has a cash value build-up, and sometimes pays dividends. You do not need to renew a whole life policy. As long as you pay your premiums, you will have coverage, usually until your death. The premium for a whole life policy generally remains the same for the period specified in the policy. Part of each premium goes into the cash value of your policy. The cash value may grow at a guaranteed rate, depending on the policy terms. Growth is generally tax-deferred.
You can borrow against your cash value. If you die with an outstanding loan amount, the loan amount, plus interest, will generally be subtracted from your death benefit.
Dividend-paying whole life policies, termed “participating” policies, are usually offered by mutual life insurance companies. Mutual life insurance companies are generally owned by policyholders while other insurance companies are owned by shareholders. Dividends depend on the insurer’s financial results and are not necessarily guaranteed. Premiums for participating policies may be higher than those paid for non-participating policies.
Term policies can also be participating, but the dividends paid are usually minimal.
Universal Life. Universal life, also known as “flexible premium adjustable life,” is similar to whole life, but offers more flexibility in terms of payment of premiums and cash value growth. With a universal life policy, your premium is credited to your cash value, and the company deducts the cost of your death benefit and policy expenses. The cash value may earn interest, depending on the policy terms. Growth is generally tax-deferred, and you may be able to borrow against it or make partial withdrawals.
A special feature of universal life is that you can vary the premium paid from month to month within certain limits. You can pay more or less without necessarily jeopardizing your coverage. However, if premium payments and cash value are insufficient to cover policy charges, your policy may lapse. Review policy statements and projections carefully.
Variable Universal Life. Variable universal life allows you to choose investments for your cash value. You have the potential for greater cash value growth, but you also have added risk, depending on the investments you choose.
Variable Whole Life. With variable whole life, the death benefit and cash value depend on the performance of the investment options you choose. Greater potential returns come with investment risk.
How Insurance Products Differ
Here, in table form, is a summary of the different features of the various types of life insurance.
| Feature | Term Life | Universal Life | Whole Life | Variable Whole Life | Variable Universal Life |
|---|---|---|---|---|---|
| Policy term | Stated in policy | Depends on policy terms | Lifetime coverage if maintained | Lifetime coverage if maintained | Depends on policy terms |
| Type of death benefit | Generally specified | May vary | Generally specified | May vary | May vary |
| Existence of cash value | No | May earn interest, subject to policy terms | May have guaranteed cash value | Investment-dependent | Investment-dependent |
| Ability to choose cash value investments | N/A | Generally no | No | Yes | Yes |
| Regulatory agency | Insurance regulators | Insurance regulators | Insurance regulators | Insurance and securities regulators | Insurance and securities regulators |
How To Shop For Insurance
In order to be able to shop for the best premiums, it’s a good idea to know how premiums are calculated by insurers. Bear in mind that premiums vary among insurance companies, and it is a good idea to ask several insurers for their rates.
Insurance companies place individuals into risk groups such as preferred, standard, substandard, or uninsurable. The premiums charged will be commensurate with the category you are placed in. Thus, a standard risk will pay an average premium for similarly situated applicants.
If you have a high-risk job or hobby, you may be considered a substandard risk. Certain serious illnesses may make obtaining coverage more difficult or more expensive. People with conditions such as diabetes or heart disease may still be eligible for insurance, but premiums and terms can vary.
One company’s category for you may not hold with another company. Thus, it still pays to shop for insurance with other companies even though one may have labeled you “substandard.”
Once an insurance company approves you for coverage, whether it can cancel or terminate the policy depends on the policy terms and applicable law. Keeping premiums current is essential.
Shopping For A Policy
In many states, insurance rules have historically required agents to provide cost indexes that can help consumers compare policy costs. Ask your agent which comparison tools are available for the policy you are considering.
One type of index, the net payment index, gauges the cost of carrying your policy over a specified period, such as ten or twenty years. The lower the number, the less expensive the policy may be under the assumptions used. This index is useful if you are most interested in the death benefit aspect of a policy, as opposed to the investment aspect. The surrender cost index is useful to those who have a high level of concern about cash value. This index may be a negative number; a lower number generally indicates a lower cost under the index’s assumptions.
These indexes may apply to certain term and whole life policies. With universal life policies, compare projected cash value growth and cash surrender value. Cash surrender value is the amount you receive if you cancel the policy. It is not the same as cash accumulation value. If two universal life policies have the same premium, death benefit, and interest assumptions, the one with the higher cash surrender value may be more favorable, but policy charges, guarantees, and other terms must also be considered.
Here are some questions to ask about policies:
- How do cash values accumulate? An early, rapid build-up may be preferable, depending on your goals and the policy’s costs.
- How has the policy’s cash value performed in the past? Compare historical performance with the company’s projections and with other insurers, while remembering that past performance does not guarantee future results.
- Are any special features merely bells and whistles, or do they add value for you?
- What is the company’s financial strength rating? Consider ratings from established rating agencies and review what each rating means.
Editorial note: This guide contains general information about life insurance. Some examples, cost assumptions, product descriptions, and references in the original article may be dated or vary by insurer and jurisdiction. Review current policy documents and consult a qualified insurance or financial professional before making coverage decisions.
