How much life insurance you purchase depends on how much you actually need and what you need the life insurance to accomplish. Although it would take a dissertation rivaling the Patient Protection and Affordable Care Act to detail every individual situation, circumstance, and appropriate calculation, there are some general guidelines to help those purchasing life insurance get a good gauge on how much life insurance they should purchase.
Dependents can be used as a good rule of thumb for purchasing life insurance. Typically, the more dependents one has, the more life insurance is needed. Of course, life expectancy of the dependents should also be considered and even those without dependents should carry some life insurance. Here are four common situations:
1. Minor Dependents. The younger the child, the longer he/she will be dependent upon the parents’ income. Insurance should account for how long the child will need to be cared for should you die. There also should be enough insurance coverage to provide for new childcare or housekeeping services if a currently unemployed parent will need to find employment upon the death of their spouse. Ideally, when both parents currently work, they should each have insurance coverage that will sufficiently cover whatever amount they contribute to the household. At the very least, the higher-earning parent should be covered.
2. Dependents Other Than Minor Children. Examples of other dependents would include aging parents or a disabled family member that relies upon your income. The coverage amount should be based on how long the dependent is expected to live and how much income would be needed to maintain the same quality of life for that amount of time.
3. Couples without Dependents. If both spouses could live comfortably in the event one dies, then substantial amounts of life insurance is usually unnecessary. Life insurance should ideally cover medical expenses, owed debts, burial expenses, and any charitable donation desired. In the event that one spouse is a substantially higher earner than the other or the spouse would be left in financial hardship should a death occur, then the life insurance might need to be adjusted accordingly.
4. Singles without Dependents. Again, substantial amounts of coverage are generally unnecessary in this case. The life insurance should be enough to cover debts and burial expenses. Premiums are generally much cheaper for younger individuals. So, it’s actually fairly affordable if more insurance is desired to leave a charitable contribution or lock in a lower premium rate for the future. Experts once recommended for individuals to purchase life insurance five to six times their annual salary. However, a more reliable estimation is from using actual living expenses and the ensuing deficit that would occur from an absent salary. This can be accomplished as follows:
Figure the amount of income existing family members would need to maintain a comfortable lifestyle, which includes property taxes, mortgage or rent, property and vehicle insurance, property maintenance and repair, appliances, utilities, car payments, food and essentials, health insurance, child care, travel and recreation, and so forth.
Next, subtract the annual costs from above from other income sources, such as social security, spousal employment, or retirement that would remain in the event of your death. If unsure about Social Security survivor’s benefits, the Social Security Administration can provide an accurate estimate. Of course, the actual amount will depend on the age of the surviving children, your earnings, and the age at which you die. For children under sixteen-years-old, a good estimate is usually $4,000 annually for one child and $5,000 annually for two or more children.
Subtract the annual expenses from the other income sources to determine the deficit you’ll be working with.
The insurance coverage benefit should ideally be large enough that post-tax annual investment proceeds will cover the annual deficit, without your survivors dipping into the principle. The amount needed can be determined by dividing the deficit by 4% to 6%. Four or five percent leaves room to account for interest rate variations and inflation. You will also want to include any expenses that will be incurred upon death, such as funeral costs, medical bills, estate administration fees or taxes, children that will be going to college, and an uneducated or undereducated spouse that might need to return to school.
As mentioned above, it simply isn’t possible to cover each individual situation, circumstance, and calculation, but the above is a sturdy guideline that will be applicable in many cases. If any doubt remains about how much coverage you need, a professional life insurance agent can help you fine tune the above information to account for your circumstances.