How Much Life Insurance Should You Own?

Ask that question of different people -- say, an insurance agent, a financial planner, an accountant, or an estate planning attorney -- and you're likely to get different answers, some helpful, some not so helpful.

Insurance agents, for example, generally work on commission, so the more you buy, the more they make. This doesn't mean that insurance agents think only of the commission when talking to you about life insurance. But it does mean that even if your agent isn't thinking about the commission, you probably are.

Financial planners and accountants may earn commissions from the sale of life insurance, too, but commissions aside, these professionals, along with estate attorneys, see insurance as tools for solving specific problems.

The Truth About Life Insurance

Here's the main basic truth about life insurance: People buy it to keep their loved ones from the poorhouse if they die. It's that simple.

Here are some more basic truths: The people in position to know how much insurance you should have, and of what kind, are you and your spouse. The two of you know your family better than anyone else, starting with the most important factor in figuring out how much coverage to buy: the degree to which your family depends on each of you to keep body and soul together.

How to Calculate How Much Life Insurance You Need

No matter what the experts say, buying the right kind of insurance, in the right amount, isn't a complicated deal. In fact, if you follow a few simple steps, you can figure out how much insurance you need in short order.

Start with the basics -- your age, your income, your family situation. Generally speaking, the younger you are, the more money you make, and the bigger your family, the more insurance you need.

How much? The wily agents of yesteryear had a simple rule of thumb: "If you need insurance, buy ten times your annual income and you'll be OK." That kept things simple, but the result didn't always fit the need.

The conventional wisdom in the life insurance industry these days is that a breadwinner (i.e. the family member that makes the most money), should own insurance equal to:

  • 25 times annual income at age 25
  • 20 times annual income at age 35
  • 15 times annual income at age 45, and
  • 10 times annual income at age 55

Run the numbers and you see that a person age 25 earning $50,000 per year needs $1.25 million in coverage. Or a person age 35 earning $100,000 needs $2 million, and so on.

The rationale here is that if the policy holder were to die, an insurance policy with $1.25 million in coverage will give the family of a 25-year-old an income of $50,000 per year, assuming the family invested that sum into something earning a modest 4% per year.

Key: You Need Less Coverage the Older You Get

When you're young and starting a family, you face enormous costs in raising and educating your children, and the death of a spouse can have devastating financial consequences on the family's expectations for the future. But you're not exactly in your peak earning years at age 25, so you don't have lots of extra cash for insurance premiums. Coverage totaling $1.25 million is a compromise (lower premium payments for a decent size payout in case the worst happens), but not a bad one.

As you move through the next three decades, your earning power increases, but you also put many of the costs of raising children behind you, only to face the biggest of the big-ticket items on your list of things to do for your children -- sending them to college. Thus, an individual age 45 earning $150,000 needs $2.25 million in coverage.

Finally, at age 55 you face retirement, and having spent all that money civilizing your brood, you may find yourself approaching the golden years with money not exactly coming out of your ears. Life insurance at this point protects your spouse; if you earn $200,000, $2 million in life insurance coverage will probably enable your spouse to keep body and soul together while you're off meeting your maker.

Factor in Special Circumstances

Once you have a basic number, you should factor in the impact of any special circumstances. Do you have a child with special medical needs? A parent or sibling who depends on you financially? Do you carry heavy debts -- for example, your mortgage -- that you don't want your dependents to have to pay for? The amount of insurance coverage you buy should reflect any such obligations.

How to Choose the Right Insurance Plan

As to what kind of insurance to buy, the answer is simple: The order of the day is to buy insurance to meet your needs (check out our insightful article How to Pick the Right Life Insurance for You). Term life insurance may be ideal for the young person with heavy family responsibilities and a limited budget. But a whole life insurance policy, held for the long term, with dividends used to purchase additional coverage, represents a relatively good use of money.

Term life insurance policies offer you guaranteed coverage with fixed premium payments over 10, 20, or 30-years (your preference), so you can plan to have your coverage end when your kids move out or if you have enough assets to provide for your family if something happens to you.

Consider Avoiding Premium Waivers or Accidental Death Benefits

Think twice about the doodads with which insurance agents like to festoon even the simplest term life insurance policy -- the waiver of premium benefit, for example, or the accidental death benefit.

As the term suggests, the waiver of premium benefit frees you of the necessity of paying your premiums in the event that you become disabled and can't work. This sounds like a good idea, since disability, like death, can have a devastating financial impact on your family. But the reality is that most waiver-of-premium clauses are so restrictive as to be not worth the paper they're printed on. So step carefully.

If your insurer offers to be nice to you only if you are so disabled as to be unable to engage in work of any kind, say thanks but no thanks. Why? People become disabled all the time, but the number who become so disabled that they can't work at all is vanishingly small, and you're not likely to become one of them. Ditto with accidental death benefit clauses. You might die in an accident, but the chances are pretty small. Just say no.

If your family depends on you financially, life insurance can give you the assurance that your family will be provided for in the event that you can't provide. Get term life insurance if you want to save on premium costs, but use the table above and talk with your agent or financial advisor to be sure you get a right amount of coverage for your family's needs.

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