For most people, it’s pretty simple deciding whether or not you need life insurance. Figuring out how much you need may be a lot more difficult.
Many people simply guess at a figure that seems reasonable and settle on that. Some use a rule of thumb that says you need six to ten times your annual income. Forbes.com has a simple life insurance calculator lets you enter how much annual income will be needed for a certain period of time after death of the policy holder.
While that’s an improvement, in today’s economy you really should approach the problem more scientifically. You could use Kiplinger’s “How much life insurance do I need?” calculator. It takes into account current assets, one-time expenses, ongoing monthly expenses, and other information such as inflation and your current tax rate. Whether you use a life insurance calculator or figure it on your own, here’s what you’ll need to consider:
Immediate needs. What would it take to pay off the mortgage or other debt and continue funding the children’s college funds? Other things to consider: funeral expenses, probate costs and, depending on the size of your estate, estate taxes.
Future needs. Essentially, you will need to estimate the amount of money your dependents would need to keep their standard of living if you were to die tomorrow. Then subtract from that figure the income they could expect to receive in social security survivor’s benefits (to get the form you need for that estimate, visit the Social Security Administration website or call 800-772- 1213).
Income when you’re gone. Next, subtract the wages your dependents now earn or could earn and figure in any investments or other income sources you may have available. The difference is the amount of income your life insurance should provide. As you make these calculations, there are a number of assumptions to consider which unfortunately scare some people away from the task.
Things to consider:
- What will inflation be in the future? Most experts says it’s safe to assume that it will average 4%.
- Will your family be able to live on the interest or earnings produced by the proceeds of the policy, or should they expect to eventually use up the capital as well? The answer to this depends significantly on how much money is involved. If the policy will pay $500,000 and there are other sources of income, then you can reasonably expect that the beneficiaries could use the earnings and leave the principal pretty much alone. On the other hand, if the policy pays $100,000, then the family will need considerable additional assets if the principal is to remain intact.
- What rate of interest can you safely assume the money will earn? For a conservative after-tax return based on historical norms, you should assume 8%.
- Will your spouse take a job if he or she doesn’t have one now? Will that require a period of training? How much can your spouse realistically be expected to earn? The answers will depend on your own situation, of course. It is impossible to anticipate everything, but it’s wise to make reasonable guesses about what sorts of choices the surviving spouse might confront and provide as much breathing room as you can afford.
As you can see, this task can be time-consuming, but is definitely worth your effort. While most insurance companies will use computerized programs that can make the financial assumptions for you, many of the decisions described above are too important to turn over completely to the company trying to sell you the policy.
Eventually you will have to pick some total insurance figure that seems a reasonable compromise between what you’d like to have and what you can afford, using the companies’ estimates for reference. Just be sure to get multiple estimates and shop around before making your decision.