How much life insurance you need depends on what you need the insurance to do. As a general rule, the more dependents you have and the longer their dependency is expected to last, the more life insurance you need. But even people with no dependents need some life insurance. Let's look at several typical situations.
People with minor children: The younger your children are, the longer they will depend on your income. Therefore, more insurance will be needed to replace the income you would have provided, should you die while they are still young. If both parents earn income, then both should have life insurance, with insurance amounts proportionate to the amounts they contribute to the family's income. If one parent stays at home with the children, there should be enough insurance to cover the cost of purchasing services, such as childcare and housekeeping, provided by this parent. Should the family budget be insufficient to purchase policies to cover both parents, most insurance experts recommend first insuring the life of the parent who earns more.
Couples with no children or other dependents: These individuals have no need for substantial life insurance if each could live comfortably without the other's income. Each should have enough life insurance to provide for burial expenses, to pay off their outstanding debts including any uninsured medical expenses, and perhaps to leave some money to charities, institutions, or valued family members and friends. If, however, you have a spouse or domestic partner who would experience hardship without the income you provide, you may need insurance to help him or her pay the bills once you are gone.
Single People Without Dependents: This group needs life insurance for burial expenses—which can easily reach $10,000—and for paying off their outstanding debts. Some may want to use life insurance as well to leave contributions to favorite charities or institutions. A young person may also want to buy life insurance so as to lock in a lower premium rate while he or she is healthy.
People who have dependents other than minor children: Some people have parents or family members with disabilities who count on their income. Their life insurance planning should be similar to that of parents with minor children—that is, based upon careful calculation of the amount of income their loved ones would need to continue living comfortably.
As a general guide to how much life insurance to buy, there is an old rule that suggests buying five, six, or seven times your annual salary. But a much more reliable estimate can be made by calculating actual living expenses and the shortfall that would occur should the family no longer have your income.
Here are some of the calculations to include: What is the amount of annual income that your survivors would need to live comfortably? This number includes mortgage or rent, insurance, real estate taxes, home repairs, improvements, furniture, appliances, and all other items bought for the home, as well as utilities and home and property maintenance. It also includes the annual cost of food and sundries, clothing, car payments and other transportation expenses, child and other dependent care, medical care, recreation and travel, and gifts.
Once you have these annual costs calculated, subtract from that figure other sources of income that would be available in the event of your death. For many, this includes Social Security survivor's benefits. You can obtain an accurate estimate by contacting the Social Security Administration. Since the actual amount would depend on your age at death, your earnings and the ages of your children, you may, instead, use the following rough estimates as a guide: $4,000 per year if you have one child under 16, or $5,000 for two or more children under 16. Other sources of income include earnings of your spouse or other household members, pensions, investment income, etc.
Then determine the shortfall between annual expenses and income from other sources. Ideally, the insurance benefit will generate after-tax annual investment proceeds sufficient to cover the annual income shortfall without touching the principle. This can be determined by dividing the shortfall by 4%, 5%, or 6%, depending on how conservative you want to be. It is reasonable to expect an annual return of 6%, but more conservative to account for inflation and interest rate risk by using one of the lower numbers.
Next, you need to determine one-time expenses that will be incurred upon your death. These include funeral costs, any likely unpaid medical expenses, costs of estate administration and estate taxes, debts that your survivors may need to pay off at the time of your death, future education expenses for each child, and any other likely expenses, such as the cost for a surviving parent to go back to school to increase his or her earning power. Add this amount to the amount of insurance proceeds needed that you already calculated to get an estimate of the total death benefit needed.
It's impossible in an article of this length to go through in detail all the calculations that can be necessary to cover each individual's situation. The above is only a general guideline as to the type of analysis that will help most people get an accurate reading on the question of how much life insurance to buy. Your insurance agent can help you refine this analysis to more accurately reflect your own situation.
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