Almost everyone needs life insurance. If someone will be financially hurting if you pass away, you need life insurance. Determining if you need life insurance is easy; but, determining how much life insurance you may need is a little harder, and much more important. One thing to remember is that life insurance is there to replace you financially. Though you physically cannot be replaced, your lifetime’s income can. This guide should help you determine how much insurance you need.
We’ll use a fictitious family to help illustrate how much insurance you may need. Meet John and Jane Smith. John and Jane make $40,000 and $30,000 respectively. They have two kids, Jack and Jill. Jack is 12 and Jill is 10. Here is a look at how much life insurance they will need for their family.
If someone in your family were to pass away today, there would be some immediate expenses come up. The biggest expense is a funeral. The average funeral can cost between $10,000 and $15,000.
The next thing to think about is paying off all outstanding debts. The most important debt to pay off is your mortgage, or to have enough money for at least ten years of rent. Then you want to pay off all other debts, including nongovernment student loans, auto loans, credit cards, lines of credit, etc. You want to be completely debt free from life insurance proceeds.
John and Jane have a $200,000 mortgage, student loans for $50,000, two car loans for $18,000, and three credit cards for $1,500 total.
The next step to consider is if you want to provide your children with any funds for school, or other financial support. The cost of school is increasing every year, and depending on if you go to a public or private college, a degree could cost hundreds of thousands of dollars in the near future.
John and Jane want to provide Jack and Jill $10,000 a year in school support for a four-year degree.
With all housing, debts, and school paid for, all that is left is day to day living expenses. You’ll need 70-80% of your current income to cover living expenses. In order to have enough money for living expenses for the rest of your family’s lives, you need to have a large amount of money. This large amount of money should be invested in relatively safe investments to provide a constant source of income for your family. A “safe investment” will return no more than 4-5%; not 10-12% that some people will quote with stocks in the stock market. You don’t want to ride the stock market roller coaster with your living money. In order to find out how much insurance you will need, you take your current income, multiply that by 80%, then divide that number by 4%. This will give you your large lump sum that you need for living expenses.
Jack’s income is $40,000. $40,000 x 80% / 4% equal $800,000. Jill’s income is $30,000. $30,000 x 80% / 4% equal $600,000.
Add this all together
When you add this all together, Jack’s insurance needs are $1,164,500 and Jill’s insurance needs are $964,500. They should also insure their kids, either with their own policies or with a child rider, for $10,000 - $15,000 so that if one of their children passes away, they don’t have to have the financial stress that comes with paying for a funeral on top of the emotional stress that will already be present.
While a million dollars of life insurance sounds like a lot, it really isn’t. A healthy adult can get that much insurance for very little per day, typically less than the cost of a cup of coffee. However, your family’s financial future is much more important than that cup of coffee. Remember, you are replacing yourself financially. In our example family, if John worked another 30 years without a single raise, he would make $1.2 million, so to replace him financially is at least around that much.
Your situation is unique, and you should talk to an experienced, licensed insurance agent to find out what is best for your situation.